What is diversification? Many investors know that they should be diversified, but don’t understand what that really means. Here, we break it down for you—along with four big misconceptions about being diversified.
When you invest, it’s good to mix things up.
Diversity applies to many things in life—our friends, our colleagues, food, and sports—but it is most well known in the context of investing, and it’s commonly referred to as being diversified.
Many investors know that they should be diversified, yet they often misunderstand—and therefore misapply—the concept. That can leave investors with more risk than they should bear, or not enough risk to effectively maximise their investment returns.
Diversification occurs when an investor spreads money across different investments in a portfolio.
Consider a collector who holds sports memorabilia (which he enjoys) and artwork (which he doesn’t), versus another who only collects sports items.
Over time, the collector who holds both art and sports items may benefit from a well-rounded portfolio, whereas the sports collector’s portfolio value will depend on the demand unique to sports to retain value or relevance.
The logic behind this diversification strategy is that a mix of collectables will, on average, have less extreme swings in value over time. The mix will also return a healthy average compared to any single group of collectables on its own.
The same applies to a solid investment diversification strategy.
When one asset surges, another may trail. Assets can be driven by various underlying factors, for example one may be more heavily tied to economic health (stocks) than others (bonds).
As long as two or more investments don’t move in the same direction all the time, but do go up on average, they can diversify a portfolio.
Diversification aims to reduce exposure to any one specific risk, and the volatility accompanied by inevitable market ups and downs.
While diversification can apply to many investments, including those in property such as real estate, art, or even gold, in this context we’ll discuss diversification as it relates to portfolio allocations in stocks and bonds.
When you hear investing professionals talking about diversification, they’ll typically mention stocks and bonds. The reason: How you invest your portfolio across both types of asset classes is one key element of diversification.
Stocks are tied to the price of a share in a particular company, and these prices can vary by the second.
When traders or investors discuss stocks, they’ll also often generally refer to them as equities. Stocks are a go-to when investors want to take on more risk in search of higher returns.
On the other hand, bonds are certifications and issuances of debt to be paid back by companies, institutions, or even governments. Prices on bonds also vary, however are generally far less volatile than equities.
Stocks and bonds commonly have an inverse relationship. Stocks tend to rise when economic growth accelerates. On the other hand, investors often allocate their money to bonds and bond funds when they are anxious about the near future and want their money to be more stable.
As a general rule of thumb, a mix of stocks and bonds are part of any diversified portfolio, because one is inclined to zig when the other zags.
While the principle of diversification may be fairly easy to grasp, there are instances when investors misinterpret the concept.
No investment strategy is without its risks, which is why simply diversifying a portfolio cannot produce miracles. It cannot eliminate the possibility of negative returns.
Diversification can also create anxiety when one asset outperforms the other, and the underperformer is a drag on overall performance. You often find yourself having to invest in things you dislike.
Unfortunately, there is no crystal ball that predicts the way any stock, bond, or market will behave, only hindsight.
While past performance helps to inform us about the size of potential movements and how they move in tandem with others, attempting to predict the precise short-term trajectory of investments is a guessing game.
Investors may also believe that they are diversified when they are invested in different “places.”
For example, if you’ve accumulated several retirement accounts from working at multiple employers over the years, holding accounts with different brokers does not translate to being diversified, especially since these accounts are generally invested in similar underlying assets.
If you have three funds that all invest in U.S. large-cap stocks (say, those appearing on the Standard & Poors 500 index), held at different places, it’s possible you’re paying more than you would than were they all managed by one broker.
Investors who simply own a large number of well known U.S. stocks may think they have a well-diversified portfolio, but they likely do not.
Diversification is not just a matter of holding numerous investments but an adequate number of investments that move independently or opposite from one another. Holding investments in both Ford and GM, for instance, is not actually a very diversified strategy.
There’s also an investing myth about buying one good stock to keep for life. Proponents point to such “blue chips” and love to talk only about winners, but seem to forget about the losers.
Overconfidence is a well-known and prevalent investment attitude, but is nonetheless irrational in the face of the value of diversification.
Constantly adding to a medley of assets makes a portfolio more complicated, expensive, and no less risky—possibly even riskier.
Investing in a newer breed of well-marketed exotic funds and more asset classes may also provide a false sense of security in diversifying, but remember:
Complexity is not diversity.
Costs are often higher for vehicles that hold exotic assets, and the more investments, the more trading and transaction costs involved, and thus more fees.
If you’re adamant about or particularly tied to a certain investment, set aside a small percentage of your wealth for just that —and wisely diversify the rest.
A single investment as an overall investment strategy generally exposes you to much more risk than necessary.
When diversifying avoid the common misinterpretations about diversification as stated above. No amount of wealth or confidence will ever be enough to protect you from risk as well as diversification can.