Why Diversification Matters

Diversification is essentially the opposite of having all your eggs in one basket – it involves using many different asset classes as well as different investment products and companies within those asset classes, to diversify or vary your exposure.

By diversifying your investments, you can help lower the impact of a damaging event in a specific company on your portfolio’s returns, as well as the day-to-day volatility of your portfolio.

How Does Diversification Work?

When you invest in a company by buying stock, you expose yourself to the risk associated with that company. If the stock price drops, your investment loses value. By diversifying and having multiple company stocks in your portfolio, you reduce the impact that such an event would have on your overall returns. The other stocks buffer your investment, so to speak.

Let’s look at an example:

• Portfolio 1: Company A ($50,000), Company B ($50,000).
• Portfolio 2: $10,000 each in 10 different companies.

If Company A’s stock drops 50%, Portfolio 1 loses 25% of its total value, falling from $100,000 to $75,000.

In Portfolio 2, that same 50% drop in Company A would only result in a 5% loss, reducing the portfolio value from $100,000 to $95,000.

This is a very simple example, but it illustrates how diversification protects you. 

Expanding Diversification Beyond Stocks

Diversification isn’t limited to holding multiple stocks. Many investors diversify across different asset classes, such as:

• Stocks
• Bonds
• Commodities (e.g., gold or oil)
• Real estate
• Alternative investments (e.g., private equity or cryptocurrencies)

Geographic diversification is another layer to consider. Investing in companies and assets across various countries can shield your portfolio from localized economic downturns.

By holding a mix of asset classes and geographic exposures, your portfolio’s overall performance is less dependent on the fortunes of any single market or asset. In fact, some asset classes often move in opposite directions, helping offset losses in one area with gains in another.

ETFs and Mutual Funds: Simplified Diversification

It can be difficult for an investor to decide what assets to buy to diversify their portfolio enough to gain the benefits of diversification, let alone actually buy the assets without commission costs quickly adding up. That’s where ETFs (Exchange-Traded Funds) and Mutual Funds come in.

These investment vehicles provide built-in diversification by pooling together a wide range of assets. For instance:

• ETFs typically replicate an index, like utility companies or tech firms.
• Mutual Funds are often actively managed, focusing on specific strategies, sectors, or asset classes.

Why Diversification Matters?

Diversification is a powerful tool to minimize portfolio volatility and shield your investments from unpredictable, damaging events. While no strategy can eliminate all risk, diversification helps balance your portfolio and smooth out returns over time.

By diversifying, you create a more consistent and stable foundation for your investments. Whether you’re a seasoned investor or just starting, diversification is one of the simplest ways to help safeguard your financial future.