The Importance Of Diversification

What Is Diversification in Investing?

Diversification is a technique that reduces risk by allocating investments across various financial instruments, industries, and other categories. It aims to minimize losses by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

Understanding Diversification in Investing

Let’s say you have a portfolio that only has airline stocks. Share prices will drop following any bad news, such as an indefinite pilot strike that will ultimately cancel flights. This means your portfolio will experience a noticeable drop in value. You can counterbalance these stocks with a few railway stocks, so only part of your portfolio will be affected. In fact, there is a very good chance that the railroad stock prices will rise, as passengers look for alternative modes of transportation.

This action of proactively balancing your portfolio across different investments is at the heart of diversification. Instead of attempting to maximize your returns by investing in the most profitable companies, you enact a defensive position when diversifying. The strategy of diversification is actively promoted by the U.S. Securities and Exchange Commission. Here are the main aspects of diversification:

Diversifying Across Sectors and Industries

The example above of buying railroad stocks to protect against detrimental changes to the airline industry is diversifying within a sector or industry. In this case, an investor is interested in investing in the transportation sector and holds multiple positions within one industry.

You could diversify even further because of the risks associated with these companies. That’s because anything that affects travel in general will hurt both industries. This means you should consider diversifying outside of the industry. For example, if consumers are less likely to travel, they may be more likely to stay home and consume streaming services (thereby boosting technology or media companies).

Diversifying Across Companies

Risk doesn’t necessarily have to specific to an industry—it’s often present at a company-specific level. Imagine a company with a revolutionary leader. Should that leader leave the company or pass away, the company will be negatively impacted. Risk specific to a company can occur regarding legislation, acts of nature, or consumer preference. Therefore, you might have your favorite airline you personally choose to always fly with. However, if you’re a strong believer in the future of air travel, consider diversifying by acquiring shares of a different airline provider as well.

Diversifying Across Asset Classes

So far, we’ve only discussed stocks. However, different asset classes act differently based on broad macroeconomic conditions. For example, if the Federal Reserve raises interest rates, equity markets may still perform well due to the relative strength of the economy. However, rising rates decrease bond prices. Therefore, investors often consider splitting their portfolios across a few different asset classes to protect against widespread financial risk.

More modern portfolio theory suggests pulling in alternative assets, an emerging asset class that goes beyond investing in stocks and bonds. With the rise of digital technology and accessibility, investors can now put money into real estate, cryptocurrency, commodities, precious metals, and other assets with ease. Again, each of these classes have different levers that dictate what makes them successful.

Diversifying Across Borders

Political, geopolitical, and international risks have worldwide impacts, especially regarding the policies of larger nations. However, different countries operating with different monetary policy will provided different opportunities and risk. For instance, imagine how a legislative change to U.S. corporate tax rates could negatively impact all entities within the United States. For this reason, consider broadening your portfolio to include companies and holdings across different physical locations.

Diversifying Across Time Frames

When considering investments, think about the time frame in which they operate. For instance, a long-term bond often has a higher rate of return due to higher inherent risk, while a short-term investment is more liquid and yields less. An airline manufacturer may take several years to work through a single operating cycle, while your favorite retailer might post thousands of transactions using inventory acquired same-day. Real estate holdings may be locked into long-term lease agreements. In general, assets with longer timeframes carry more risk but often higher returns to compensate for that risk.

How Many Stocks You Should Have

There is no magic number of stocks to hold to avoid losses. In addition, it is impossible to reduce all risks in a portfolio; there will always be some inherent risk to investing that can not be diversified away.

There is discussion over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries. Other views contest that 30 different stocks are the ideal number of holdings. The Financial Industry Regulatory Authority (FINRA) states diversification is specific to each individual and to consider the decision after consulting an investment professional or using your own judgment.

For investors that might not be able to afford holdings across 30 different companies or for traders that want to avoid the transaction fees of buying that many stocks, index funds are a great choice. By holding this single fund, you gain partial ownership in all underlying assets of the index – which often comprises dozens (if not hundreds) of different companies, securities, and holdings.

Different Types of Risk

Investors confront two main types of risk when they invest. The first is known as systematic or market risk. This type of risk is associated with every company. Common causes include 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. This risk is specific to a company, industry, market, economy, or country. The most common sources of unsystematic risk are business risk 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 the same way by market events.

Benefits of Diversification

Diversification attempts to protect against losses. This is especially important for older investors that need to preserve wealth towards the end of their professional careers. It is also important for retirees or individuals approaching retirement that may no longer have stable income; if they are relying on their portfolio to cover living expenses, it is crucial to consider risk over returns.

Diversification is thought to increase the risk-adjusted returns of a portfolio. This means investors earn greater returns when you factor in the risk they are taking. Investors may be more likely to make more money through riskier investments, but a risk-adjusted return is usually a measurement of efficiency to see how well an investor’s capital is being deployed.

Some may argue diversifying is important as it also creates better opportunities. In our example above, let’s say you invested in a streaming service to diversify away from transportation companies. Then, the streaming company announces a major partnership and investment in content. Had you not been diversified across industries, you would have never reaped the benefit of positive changes across sectors.

Last, for some, diversifying can make investing more fun. Instead of holding all of your investment within a very small group, diversifying means researching new industries, comparing companies against each other, and emotionally buying into different industries.

Problems with Diversification

Professionals are always touting the importance of diversification but there are some downsides to this strategy. First, it may be somewhat cumbersome to manage a diverse portfolio, especially if you have multiple holdings and investments. Modern portfolio trackers can help with reporting and summarizing your holdings, but it can often be cumbersome needing to track a larger number of holdings. This also includes maintaining the purchase and sale information for tax reasons.

Diversification can also be expensive. Not all investment vehicles cost the same, so buying and selling will affect your bottom line—from transaction fees to brokerage charges. In addition, some brokerages may not offer specific asset classes you’re interested in holding.

Next, consider how complicated it can be. For instance, many synthetic investment products have been created to accommodate investors’ risk tolerance levels. These products are often complex and aren’t meant for beginners or small investors. Those with limited investment experience and financial backing may feel intimidated by the idea of diversifying their portfolio.

Unfortunately, even the best analysis of a company and its financial statements cannot guarantee it won’t be a losing investment. Diversification won’t prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.

Last, some risks simply can’t be diversified away. Consider the fallout from the COVID-19 pandemic in March 2020. Due to global uncertainty, stocks, bonds, and other classes all fell at the same time. Diversification might have mitigated some of those losses, but it can not protect against a loss in general.

The Bottom Line

Diversification can help an investor manage risk and reduce the volatility of an asset’s price movements. Remember, however, that no matter how diversified your portfolio is, risk can never be eliminated completely.

You can reduce the risk associated with individual stocks, but general market risks affect nearly every stock and so it is also important to diversify among different asset classes, geographical locations, security duration, and companies. The key is to find a happy medium between risk and return. This ensures you can achieve your financial goals while still getting a good night’s rest.