What Is Diversification?
You’ve heard it before – don’t put all your eggs in one basket. This couldn’t ring any truer for investments. If you put everything you own in one investment, you could lose everything in one fell swoop.
Any investor, beginning or experienced, shouldn’t take the chance. Everyone must diversify among asset classes and even within each asset class.
It sounds more confusing, but once you understand how it works, you’ll want to diversify your portfolio as much as we want you to.
Let’s walk through what diversification is and how it works to give you a better understanding.
At its most basic level, diversification means spreading your money across various assets. But it also means investing in different types of assets. For example, you could buy different stocks and say you diversified your portfolio. Let’s say you invested $100,000 in the stock market.
Now it crashes.
If you only invest in stocks, you lose everything – your entire $100,000 investment. If you diversify across asset classes, you may offset some of the losses as it’s rare for all asset classes to lose value at the same time.
Let’s say, for example, you invested part of the money in stocks, some in bonds, and the rest in mutual funds. You’ll have a well-diversified portfolio that will have a lower risk of a total loss.
Please note, diversification doesn’t mean you can’t lose money. You can always lose no matter how well you plan or spread out your investments. Diversification lowers the risk of losing everything, but it’s not a guarantee. It’s a great strategy to implement in any savings or investments you make so you offset the risk of a total loss.
Why is Diversification Important?
Diversification helps you reach your goals. Like we said above, if you invest in one asset, there’s a large chance you could lose everything.
If you spread your money across multiple assets, you spread out the risk. But people diversify for other reasons too:
- Diversifying risk – This is the main reason people diversify. You offset the risk of one asset with another. A common example is mixing up your portfolio with stocks and bonds. Stocks are risky. They may do well or they may tank – there’s no way to predict it. Bonds are less volatile. They are relatively safe or have a lower risk. When you spread your portfolio across both, you even out the risk.
- Investment needs – Diversifying for your investment needs means spreading your investments across a variety of types of assets. For example, a portion of your portfolio may be in aggressive investments while another part is in income-producing, and another in appreciation. Income-producing assets bring cash flow, aggressive investments may or may not, and appreciating assets, like real estate, grow over time.
- Liquid and non-liquid assets – Some investors need a portion of their portfolio to be liquid. It’s great for emergencies or just peace of mind. Investing some of your money in cash-like investments while putting a larger portion in non-liquid investments diversifies your assets across the board. You’ll have peace of mind knowing you can access some of your money while you leave other money be, allowing it to grow.
- Time – Investing in all short-term investments doesn’t leave a lot of time for growth, but putting everything in long-term investments takes too much time. Diversifying your money across both types of investments ensures you get the returns you want while having access to funds as you need them.
Diversification of Asset Classes
There are two major assets classes you can diversify your money in:
- Traditional – Stocks and bonds
- Alternative – Real estate, collectables, and private equity
Most people only think of stocks and bonds assuming if they diversify their money across both, they’ll be okay and they might.
But a properly diversified portfolio diversifies across stocks, bonds, real estate, collectables, and private equity. It may also include cash accounts, commodities, and other tangible assets. The key is to have your money in different assets that either appreciate, are income producing, or are aggressive to help you meet your financial goals.
Diversification within Asset Classes
Even if you diversify across asset classes, you should also diversify within each asset. Like we talked about above, you shouldn’t put all your money in one stock, even if you diversify your funds across stocks and bonds.
Diversifying within asset classes ensures that you don’t lose everything should one company fall apart. It’s best to invest in not only different stocks but stocks in different industries. For example, if you invest in some tech stocks, don’t put all your money in only tech stocks, consider diversifying in other industries. This way if the tech industry tanks, but the other industries do okay, you won’t be at risk of losing everything.
Diversification Helps you Reach your Goals
Many people assume they should invest aggressively to reach their financial goals. Sometimes, yes, you should invest aggressively, but you must offset the risk. If your aggressive investments have a loss, the less will be greater than your conservative investments.
When you spread out the risk, you’ll have a better chance of reaching your goals. Rebalancing your portfolio to achieve those goals is important. When you rebalance, you keep up with the diversification so you aren’t too heavily invested in one asset class or another.
The Downsides of Diversification
As with any strategy, there are downsides to diversification, but the benefits outweigh the costs.
- Diversification isn’t a guarantee – There’s no way to tell if you are diversifying the ‘right way.’ What if you pick all ‘bad companies’? There’s no way to tell. But, the chances of a total loss when you diversify right are much lower than if you didn’t spread your money across multiple assets.
- It’s a lot of work – Figuring out which assets to buy, which to sell, and how to do it can be exhausting, not to mention expensive. If you aren’t careful, you could trigger high tax liabilities, which takes away from your capital gains.
- It’s time-consuming to manage the portfolio – If you have a rather diverse portfolio, you’ll be all over the place watching the performance and making decisions.
Always Diversify your Portfolio
No matter what you’re investing for or for how long, always diversify. Even if you keep a portion of your portfolio in cash, some in aggressive investments, and some in conservative assets. You need a way to offset losses in one asset class and even within each asset class. The more assets you invest in, the better your chances of reaching your financial goals.