What Is Diversification and What Is It’s Purpose?
It’s wise not to have too much of your money riding on any one investment because investments can be unpredictable and subject to risk.
By diversifying, or spreading, your money across a range of different investments, you can help reduce the potential impact to your portfolio if something were to go wrong with any one investment.
It’s a basic investment concept, and it’s not hard to implement. However, there’s a right way and a wrong way to diversify your portfolio.
What Is Diversification?
In its most basic form, diversification refers to how many different investments you own. The idea is to own different things to spread out the risks to your investment portfolio.
Suppose you owned just one stock. All of your risk and investment returns would depend on what happened to that one stock.
If that stock turns out to be the next Apple, great. If it turns out to be the next Enron, then you’re in trouble.
Since that kind of all-or-nothing risk is not a sound investment strategy for funding retirement and reaching other financial goals, most people don’t put all their money in one stock.
Can You Measure Diversification?
It’s good to ask how many different investments you need to achieve a diversified portfolio.
This can be measured by seeing how many different stocks it takes before a portfolio is no more risky than the market as a whole.
A variety of studies have been done on this, and the results vary according to how they define risk. However, the conclusion generally has been that most of the impact of diversification can be achieved with anywhere between 15 and 60 stocks.
However, diversification is not simply a numbers game. To a large extent, diversification is determined not just by how many investments you own, but by the type of investments you own.
Think of this as not just trying to own a lot of different investments, but making sure you own investments that behave differently. You can do this through both stock diversification and asset class diversification.
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Stock Diversification
Some degree of stock diversification can be achieved just by owning several different stocks. Doing so can help limit the extent to which your portfolio is exposed to a problem with any one company.
However, some groups of stocks tend to be influenced by the same economic forces. For example, if you owned a lot of travel and tourism stocks when the coronavirus pandemic hit, you probably would have seen them all take a pretty significant hit.
Sectors in the Stock Market
The stock market is divided into sectors. These are broad classes of stocks according to the type of business they are in. Examples include financials, utilities, information technology, etc.
Sectors are then divided into more specific industry groups. Naturally, stocks within a sector, and especially those within a particular industry group are going to be influenced by similar economic developments, for better or worse.
So, one way to effectively diversify your portfolio is not just to own several different stocks, but to make sure they are spread across a variety of different sectors and industry groups.
If you diversify by the type of stock you own rather than just by the number of stocks you own, you should have a better chance of owning things that will do well under different economic conditions.
Asset Class Diversification
Of course, stocks aren’t the only types of investments you can own. Investments like bonds, cash equivalents, and real estate have distinctly different characteristics from stocks.
These different types of investments are known as asset classes. Owning different asset classes is one of the most effective ways to achieve diversification.
Cash and cash equivalents are highly liquid, short-term instruments that can be used for emergencies, opportunistic purchases of stocks and bonds, or to pay for expenses. Since they don’t fluctuate much in value, cash equivalents have a core role in any portfolio.
Different asset classes are designed to do different things. For example, cash equivalents may not provide much of a return, but they are steady and secure.
Bonds can go up and down in value, but typically not as much as stocks. Instead, they provide much of their return in the form of regular income payments.
Stocks generally provide less stability than cash or bonds but have more growth potential.
There are a variety of other asset classes, each with its own risk and reward characteristics. Each tends to rise or fall under different sets of economic conditions.
Since the purpose of diversification is to protect against having all of your investments do poorly at once, owning different asset classes gives you a good chance that at least some of your investments will hold up well when others suffer.
Benefits of Diversification
So why go through all of this? Why bother buying a large number of securities and putting together a portfolio made up of different asset classes?
Diversification is important in investing because it softens the impact of unpredictability.
Naturally, if you knew for certain which company was going to be the next Google, investing would be easy. But no one knows that.
Short-term cycles and long-term trends
Investing is unpredictable on both a short-term and a long-term basis. The benefits of diversification include helping make a portfolio more reliable through both short-term cycles and long-term trends.
For example, growth stocks do best when the economy is going full speed ahead. These same stocks tend to fall apart when the economy goes into a recession.
Meanwhile, companies that sell consumer staples – everyday things you need to buy in good times and bad – don’t typically show rapid growth during a strong economy but they hold up well during downturns.
If you own a mix of growth stocks and consumer staples, your portfolio could be positioned for both rising and falling phases of the economic cycle.
Even beyond short-term swings in economic cycles, there are long-term trends that favor some types of stocks over others.
In the case of tech stocks, there was a time when the hottest tech stocks were computer hardware manufacturers like IBM. Then there was an extended stage where software companies like Microsoft rose to prominence. More recently, online giants like Google and Facebook have ruled the roost.
Diversification limits your exposure to short-term cycles and also guards against being completely on the wrong side of long-term trends.
The Impact of Diversification on Investment Returns
While diversification is a form of risk management, it shouldn’t be thought of in purely defensive terms.
After all, if you simply wanted to avoid the risk of losing money, you could put all your investments in an FDIC-insured account. This would keep your money safe, but it would also remove any potential for growth.
Diversification can offer a more positive approach to risk management. It can help stabilize your portfolio while also allowing some possibility of growth.
There is a trade-off between stability and growth potential. This trade-off can be measured in terms of risk-adjusted returns.
What Are Risk-adjusted Returns?
Risk-adjusted returns measure how well your portfolio did compared to how much risk you took. For example, if you are able to outperform the stock market without taking any more risk than the market, you would have a favorable risk-adjusted return.
On the other hand, if you only did 10% better than the market while taking twice as much risk, that is an unfavorable risk-adjusted return.
Risk and return often go hand in hand, so the significance of diversification is that it can allow you to limit risk more than you limit return. This is because securities generally go up and down at different times.
Suppose you had a portfolio of securities all with the same risk and return characteristics. While those securities would all have their ups and downs, just having those ups and downs occur at different times would smooth out the performance of your portfolio as a whole.
And yet, while this would cushion the risk of the portfolio, it would not reduce the overall return potential of that portfolio. That is a favorable risk/return trade-off that comes from diversification.
Diversification and Rebalancing
Diversification can further improve your risk-adjusted returns if you rebalance your portfolio. This means periodically readjusting your holdings back to a certain target mix.
As different investments in your portfolio go up and down, the ones that are up will grow to represent a bigger percentage of your portfolio. The ones that are down will shrink to a smaller percentage.
Rebalancing means selling a little of some securities while buying a little of others to restore each to their original proportions. Over time, doing this tends to result in buying low and selling high – the essence of good investing.
While this may be difficult to do with each individual security, rebalancing your mix of asset classes can be especially effective.
For example, if you start out with a 50/50 mix of stocks and bonds by percentage, as those asset classes perform differently over the course of the year that mix will change. However, you can rebalance by periodically buying or selling enough of each to put the mix back to 50% stocks and 50% bonds.
This maintains the risk profile you were originally shooting for, and may also improve your risk-adjusted returns over time by buying low and selling.
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How to Implement Your Diversification Strategy
While diversification involves owning a lot of different stocks and asset classes, it doesn’t have to involve a lot of work.
There are a few different ways you can readily achieve diversification:
- Mutual funds allow you to buy a large number of stocks all at once, or even invest in multiple asset classes with just one fund.
- Robo-advisors offer an automated approach to constructing a diversified portfolio out of a variety of investments.
- Financial advisors can personally tailor a diversification strategy to your needs and risk tolerance.
Diversification is a basic way of improving the risk/reward trade-off in an investment portfolio. With a choice of easy ways to diversify, this is a strategy you should not neglect.
Take the Next Step
Looking for alternative investments and ways to improve your investment returns? Consider discussing your investment strategy with a financial advisor.
