What is Diversification & Why is it Such a Big Deal?

Diversification is often mentioned as a fundamental and necessary part of any financial planner‘s investment portfolio strategy.

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

How Does Diversification Protect You?

When you invest in a company by buying stock, you expose yourself to the risk associated with that company. When the stock price drops, your investment will lose 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.

For example, compare the following two simulated portfolios:

Portfolio 1: Company A ($50,000), Company B ($50,000)

Portfolio 2: $10,000 of 10 different companies

If Company A drops 50% in value, the overall portfolio drops 25% from $100,000 to $75,000.

However, if Company A were only 10% of a portfolio, as in Portfolio 2, that 50% drop would only cause the overall portfolio to drop from $100,000 to $95,000.

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

Many investors will also expand their diversification to include multiple different asset classes, such as investing in a mix of stocks, bonds, commodities, real estate, and other alternative investments, as well as in different countries.

Doing this can provide even further protection against events like bear markets or fluctuations in economic stability.

In the same way, as stocks can be diversified within your portfolio, so too can asset classes. By having a wide array of companies and assets, your portfolio’s returns will less resemble a specific asset class but rather average out to a generally expected return based on your asset allocation.

Because certain asset classes often move opposite one another, diversification allows you to protect yourself better against volatility as well as extended downturns in certain asset classes  

ETFs and Mutual Funds

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.

ETFs and Mutual Funds offer diversification in one simple investment vehicle. Many of these funds will hold dozens or even hundreds of different stocks, bonds, and other assets, allowing you to own a piece of their already-diversified portfolio.

ETFs usually replicate an index, such as utility companies or Internet companies. In contrast, Mutual Funds will often be actively managed and focus on either a specific strategy or particular sector or asset class.

Why Does This Matter To You?

As an investor, you want to be able to minimize your portfolio’s volatility and protect yourself against rare but damaging events from harming your overall portfolio.

Diversification offers an effective and easy means of doing so. There are a variety of different ways to diversify and different degrees of diversification that you can pursue.

By diversifying your portfolio, you are able to keep your investments more consistent and stable in their returns. While there are no guarantees in investing, diversification offers one of the best and easiest ways of doing so.