If you’ve ever heard “don’t put all your eggs in one basket”, it’s used to describe a simple investing principle known as diversification.
What Is Diversification?
Diversification is a way to lower risk by allocating your portfolio across various investments and asset classes. In doing so, it should limit your losses and lower volatility while still providing the best possible return for your money.
Diversification is the heart of many asset allocation models. When used correctly, it will help you reach your financial goals without taking on undo risk.
Why You Diversify
The purpose of all this is to reduce investment risk and prevent losses. You do this by dividing your portfolio among different assets classes – stocks, bonds, real estate, cash, and other investments.
The reason is each asset reacts differently to market moving events. Downward swings in one asset are offset by upward swings in another. This helps lower risk. So the portion of your portfolio that makes up each asset class becomes important.
You want to balance these assets so that each portion plays a unique role in your portfolio. And to do it in a way that benefits you over the long-term. How you do it will depend on your goals, risk aversion, and time horizon.
Look at it this way. Diversification is like a balanced diet – where you get a healthy combination of fruits, veggies, protein, dairy, etc. How much of each depends on what you’re trying to accomplish. When combined correctly it reduces your health risks, you live longer, you lose weight, and all that other stuff the doctor warns you about. Or you can stuff your face with donuts and candy and see how far it gets you. I’d be willing to bet a balanced, diversified diet will take you farther in life.
Just like the perfect diet won’t eliminate every risk, diversification won’t do it either. There will always be things like interest rate risk and inflation risk to plan around. Having a basic understanding of the risks involved with each investment will help. Your goal will be to offset the risks inherent with each asset, by holding more or less of another asset class. This is where asset allocation models can help.
Just make sure you don’t take it to far.
Unfortunately, like many things, we tend to over generalize these strategies so much that it looses all meaning. What we end up with is the idea that a mishmash of funds is somehow diversified. Though far from it.
Over diversification is just a diluted mess. One where returns are diminished so much that your performance lags thanks to being spread too thin. This is similar to the misbelief that more is better. You can quickly end up with a portfolio that fails to perform up to your standards. And the risk becomes a failure to meet your goals.
The easy example is picking one of everything. Like owning every fund choice in a 401k. That is not a strategy, unless you’re at a buffet. You end up with overlapping funds that do a terrible job of protecting your money and prevent any chance of a decent return too.
This idea is explained rather simply – as the number of stocks you own increases your risk of loss decreases. Eventually you get to a point where adding one more stock does little to reduce risk. The same concept works with bonds and mutual funds and ETFs. Though you could argue that funds in their nature are over diversified. But I’ll save that for another day.
For now, most investors are better off with a well diversified portfolio of index funds. In the end, diversification is about setting basic rules that you benefit from in the long run.