Have you ever heard the term “don’t put all your eggs in one basket?” This piece of advice relates to diversification, or, the lack thereof.
Investment diversification is a risk management technique that involves increasing the variety of investments in your portfolio. By diversifying and investing in differing types of assets, many investment professionals agree that doing so is an important component to reducing investment portfolio risk. It’s important to remember though that investment risk may never be eliminated completely.
You can diversify across different types of companies and industries. For example, an investment portfolio can diversify by companies and can include shares in Apple (AAPL), Microsoft (MSFT) and Google (GOOG), but these are all the technology industry. To diversify even further, investments in other industries could be included such as stocks related to the healthcare or transportation industries. You can even diversify by location, by choosing investments in different countries.
Additionally, you can diversify across different types of asset classes, not just different types of companies or industries. Assets such as bonds and stocks react in different ways to adverse events, and diversifying across different types of asset classes so will help reduce your portfolio’s sensitivity to stock market swings. The different asset classes that you can diversify your portfolio with include stocks, bonds, real estate, exchange traded funds (ETFs), commodities and cash and short-term cash equivalents.
What is risk?
Your investment portfolio can be exposed to a variety of risk, depending on the type(s) of assets that are included. There are two main types of risk when investing: the first is undiversifiable – also known as systematic or market risk and caused by variables such as inflation, political instability and exchange rates, and the second type of risk is diversifiable – also known as unsystematic risk and specific to variables such as a company, industry, market. Like we mentioned before, investment risk may never be eliminated completely, a portfolio can be vulnerable to more risk if it’s not diversified. As an investor, you can ask yourself how much risk you are willing to take on, and that can help you decide how much you should diversify in order to properly to reach your investment goals.
Why is Diversification Important
When you diversify, you’re making sure all your eggs are not in one basket, they’re spread out over many different baskets – depending on how much you have diversified.
If you don’t diversify, certain market conditions could change rapidly and affect your investment performance. For example, if you have a portfolio that only includes airline stocks during early 2020 when the COVID-19 pandemic began to come to fruition, lockdowns started to occur leading to many flights being cancelled. Therefore, consumer demand for airlines dropped sharply and stock value dropped rapidly.
What are the advantages of diversification?
There can be many advantages to diversification. The most important is managing and reducing your investment portfolio risk through diversification.
With diversification, assets are spread over various different assets, minimizing portfolio vulnerability to major factors that affect share price or markets negatively.
To invest primarily for long-term investment goals, investors typically diversify a bit more than those looking to the short term, so that they can minimize risk to reach these investment goals.
How does diversification reduce risk?
As diversified investments perform together over time, it’s important to choose investments that are typically negatively correlated – meaning they have opposite reactions to the same market factor and they generally move together in opposite directions. So, if one asset loses value because of a negative factor, another asset may gain the loss back because of that same factor.
Taking the same example as before, if you invested in Delta Air Lines (DAL) during the COVID-19 pandemic, you would have seen the value of that share price decline. But, if your portfolio was diversified and you also held Novavax (NVAX) stock – a vaccine development company with a vaccine candidate for COVID-19 – these two stocks are negatively correlated and have had opposite reactions, therefore, your portfolio would have been diversified.
What are the Disadvantages of Diversification
Even though there can be many advantages to diversifying your portfolio, there can also be some downsides. Since diversifying means you are investing in various kinds of assets at one time, you’ll need to manage the investment of each asset in your portfolio. This can become tedious and difficult at times, especially if you have multiple holdings and investments. In addition, since diversifying helps reduce portfolio risk and vulnerability to extreme drops, the same goes for when a specific asset or market does extremely well because of a market factor. Since diversifying means the investments are spread over various assets, it can limit large gains in the short term.
What is an ETF?
This may sound like a lot to take into consideration, but don’t worry, that’s where ETFs come in. An example of an already-diversified asset option are mutual funds and ETFs. An ETF is an investment fund comprising a collection of assets that tracks an underlying asset or index. An ETF can hold a wide variety of different types of investments, ranging from stocks, bonds, commodities, and can be comprised of various indices, a collection of stocks based around a theme, and more, giving investors exposure to a wide variety of different assets with just one single investment.
But, since these are usually managed by professionals, they usually have higher fees, so ensure you weigh out the pros and cons to each investment opportunity before investing.