The Importance of Diversification
Updated: May 5, 2020
Have you ever desired to gain consistent returns while also minimizing risk? Well, diversification just might be the antidote to your problem. To put it simply, diversification is the act of investing in an array of securities that will all react differently to the same economic or social event. This does not mean that you cannot take losses, but it does allow you to minimize these losses because you haven’t tried to fit your entire nest egg into one basket.
A Simple Example of Diversification
In this example, we are going to have two brothers who are each given $1,000 to invest upon graduating high school. For ease, we will name these brothers Bob and Jim. Bob decides that he is going to invest all of his money into the hot new tech stock because he sees value in it. Jim, on the other hand, decides to invest his money into 20 stocks all from different industries, including the tech stock Bob invested in. As a few months go by, earnings for certain companies are announced. Now, let’s say that the tech stock has an atrocious earnings report, which causes the stock price to drop by 25%. Bob loses $250 because all of his capital was invested in that single stock. On the other hand, Jim’s portfolio may have only gone down a few percent because some of the other stocks in his portfolio could have gone up in value.
Now, think that $1,000 in Bob’s portfolio was actually his entire retirement fund that is worth $100,000. They could have lost $25,000 because of the lack of diversification.
How Much Should I Diversify?
Now, how much should you diversify? This question can only be answered based on your risk tolerance. Are you okay with your portfolio being massively affected by one stock dropping in value, or are you a more secure investor that is okay with lower returns as long as your investment doesn’t swing up and down constantly? So ask yourself right now: are you a very conservative investor, an aggressive one, or somewhere in between? First, if you answered aggressive investors, I would recommend investing in a portfolio with around 15 to 20 stocks in various industries. Secondly, if you answered that you are somewhere between the two, I would recommend investing in an S&P 500 index fund that tracks the majority of the US market giving you consistent returns. Lastly, if you are an extremely conservative investor, I would recommend investing in a portfolio that covers not only an array of different securities but also an array of different securities. I would recommend investing in a portfolio with a multitude of different stocks and bond funds from all economies, not just the United States.
In conclusion, diversification will benefit anyone’s portfolio by limiting theirs losses because of the tanking of individual stocks. Diversification will eliminate risk, but the amount of diversification needed is based on how aggressive an investor you are.
Disclaimer: I am not a financial advisor, so please review all of this advice with your CFP or financial advisor first.