The Importance of Diversification

Santri Alat - The Importance of Diversification - Diversification is the process of spreading investments across different asset classes, industries, and geographic regions to reduce the overall risk of an investment portfolio. The idea is that by holding a variety of investments, the poor performance of any one investment potentially can be offset by the better performance of another, leading to a more consistent overall return. Diversification thus aims to include assets that are not highly correlated with one another.

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.

“Don’t put all of your eggs in one basket!” You’ve probably heard that over and over again throughout your life…and when it comes to investing, it is very true. Diversification is the key to successful investing. All successful investors build portfolios that are widely diversified, and you should too!

Diversifying your investments might include purchasing various stocks in many different industries. It may include purchasing bonds, investing in money market accounts, or even in some real property. The key is to invest in several different areas – not just one.

Over time, research has shown that investors who have diversified portfolios usually see more consistent and stable returns on their investments than those who just invest in one thing. By investing in several different markets, you will actually be at less risk also.

For instance, if you have invested all of your money in one stock, and that stock takes a significant plunge, you will most likely find that you have lost all of your money. On the other hand, if you have invested in ten different stocks, and nine are doing well while one plunges, you are still in reasonably good shape.

A good diversification will usually include stocks, bonds, real property, and cash. It may take time to diversify your portfolio. Depending on how much you have to initially invest, you may have to start with one type of investment, and invest in other areas as time goes by.

This is okay, but if you can divide your initial investment funds among various types of investments, you will find that you have a lower risk of losing your money, and over time, you will see better returns.

Experts also suggest that you spread your investment money evenly among your investments. In other words, if you start with $100,000 to invest, invest $25,000 in stocks, $25,000 in real property, $25,000 in bonds, and put $25,000 in an interest bearing savings account.

Let's say you have an investment portfolio that only contains airline stocks. Share prices of all those stocks potentially will drop in tandem after industry-specific bad news, such as an indefinite pilots 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.

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 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 be 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 affected. Risk specific to a company can occur from legislation, acts of nature, or consumer preference. As such, you might have your favorite airline that you personally choose to fly with, but 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 push down 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 also 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 easily put money into real estate, cryptocurrency, commodities, precious metals, and other assets. 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 provide different opportunities and risk levels. For instance, imagine how a legislative change to U.S. corporate tax rates could negatively impact all entities within the U.S. 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 time frames carry more risk but often may deliver higher returns to compensate for that risk.