GUIDE TO DIVERSIFICATION
The larger the margin of safety, the easier the investment.
Diversification gives you a greater margin of safety. Holding multiple assets reduces the risk of losing everything. For example, a company with stable income and large cash reserves will be safer than a company with very slim margins and no cash reserves.
Diversification is a word you often come across when it comes to investing. Here we’ll explore diversification in investing: what it is, how it works, and how to apply it to your portfolio.
- Diversification and its benefits
- The methods of diversification
- Why is diversification important in your investing?
- How to diversify your investment portfolio?
- How many stocks should you own?
- Disadvantages of diversification and different types of risk
Diversification and its benefits
Diversification is the process of choosing different types of investments to reduce your overall risk. It is a risk-management strategy that mixes a wide range of investments into a portfolio. A diversified portfolio contains a mix of distinct asset classes and investment vehicles to limit exposure to a single asset or risk.
The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and reduce the risk of any individual holding or security. Diversifying a portfolio means investing in different assets to minimize risk. This lowers the chance of all investments being impacted during a market downturn.
Diversification is most often done by investing in different asset classes such as stocks, bonds, real estate, or cryptocurrency.
The methods of diversification
There are many ways to diversify. The primary way to diversify is to buy different types of asset classes. For example, instead of investing your entire portfolio in public stocks, you might consider buying bonds to offset some of the risks in the stock market.
In addition to investing in different asset classes, you can diversify across different industries, geographical locations, term lengths, or market caps. The primary goal of diversification is to invest in a wide range of assets subject to different risks.
Why is diversification important in investing?
When you own a well-diversified portfolio, the overall value should be much less volatile over time. Anything with significant daily price changes can be tough to hold on to and can be mentally stressful, especially as portfolio sizes increase.
Another thing to keep in mind is that certain types of investments go in and out of fashion. Thus, the entire industry could fall out of favor for months or even years, which might affect the price of each individual company in its sector, regardless of how well they perform individually.
This also works in reverse. When investors fall in love with a specific technology or industry, almost every company involved with it might see its share price rise, regardless of how strong and durable the underlying business is.
It is also important to realize that predicting an individual investment’s long-term performance is nearly impossible. In theory, betting on a single industry or technology can make you incredibly rich if you guess right and get in early, but that involves a huge amount of luck. It’s better to choose to diversify, widening the scope of your investments to increase your overall chances of success.
How to diversify your investment portfolio?
The simplest way to diversify your investment portfolio is to consider buying a low-cost index fund that tracks global stock markets. This allows you to invest in thousands of companies across various sectors and countries, making it an excellent choice for beginners. Alternatively, you could take more of a DIY approach by buying multiple index funds in the types of investments you find most appealing, like technology, smaller companies, or Asian stocks.
Choosing a diversified portfolio of individual stocks requires a bit more thought. This can be done at a high level or in great detail, depending on how deep you want to go and how experienced you are as an investor.
Diversification between different asset classes is also important. As a rough guide, the longer your investment horizon, the more exposure you’ll want to higher growth assets like stocks and equities. Likewise, if you prefer a portfolio that offers a smoother ride, you may have less exposure to the stock market and more to fixed income (i.e corporate and government bonds).
Finally, the test of whether you have achieved the right level of diversification is something you’ll only discover after you’ve invested. Do you have a portfolio that you can hold on to during tough times and when the market hits a bumpy road?
Another good thing to look at is how the individual prices in your portfolio change over time. If you find that everything goes up or down at about the same rate at the same time, that’s a pretty good sign that you may not be that well-diversified after all.
How many stocks should you own?
There is no magic number of stocks to hold to avoid losses. Furthermore, it is impossible to reduce all risks in a portfolio; there will always be an inherent risk to investing that cannot be diversified away.
There is discussion over how many stocks one needs for high returns with reduced risk. The most prevalent viewpoint contends that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries, whereas other viewpoints contend that 30 different stocks are the optimal number of holdings. Diversification, according to the Financial Industry Regulatory Authority (FINRA), is unique to each individual and should be considered after consulting with an investment professional or at your own discretion.
For investors that might not be able to afford holdings across 30 different companies, index funds are an excellent option. By holding this single fund, you gain partial ownership of all the index’s underlying assets, which often include dozens (or even hundreds) of different companies, securities, and holdings.
Disadvantages of diversification and different types of risk
With so many investments to choose from, diversification may seem easy, but that is only partially true. Investors still have to make informed choices. In addition, it is possible to over-diversify your portfolio, which will have a negative impact on your returns. Many financial experts agree that 20 stocks is the optimal number to diversify a stock portfolio. With that in mind, buying 50 individual stocks or four large-cap mutual funds could do more harm than good.
Having too many investments in your portfolio doesn’t allow any of the investments to have much of an impact, and an over-diversified (sometimes called “Diworsification”) often begins to behave like an index fund. In the case of holding a few large-cap mutual funds, multiple funds bring the additional risks of overlapping holdings as well as a variety of expenses—such as low balance fees and varying expense ratios— that could have been avoided through a more careful fund selection.
Investors confront two main types of risk when they invest. The first is known as systematic or market risk (associated with every company due to inflation rates, exchange rates, political instability, war, and interest rates). This category of risk is not specific to any company or industry, and it cannot be eliminated or reduced through diversification. It is a form of risk that all investors must accept.
The second type of risk is diversifiable or unsystematic, which is specific to a company, industry, market, economy, or country. The most common sources are business and financial risk. Because it is diversifiable, investors can reduce their exposure through diversification. Thus, the aim is to invest in various assets so they will not all be affected in the same way by market events.
Bottomline
Regardless of your means or method, keep in mind that there is no single diversification model that will meet the needs of every investor. Your personal time horizon, risk tolerance, investment goals, financial means, and level of investment experience all play a huge role in dictating your investment mix. No matter how diversified your portfolio is, risk can never be completely eliminated. However, you can reduce the risk associated with individual stocks, but general market risks affect nearly every stock, so it is also important to diversify among different asset classes, geographical locations, security durations, and companies.
