Diversification is one of the most basic but important tools used to manage risk within a portfolio. Before we jump into why diversification is so important, let us first define the term.
What is diversification?
Diversification in a portfolio is when an investor buys assets of all different types. A well-diversified portfolio will have different financial instruments, such as stocks, bonds, or ETFs, that vary in financial sector, industry, and market cap.
Let’s look at a basic example. You may know of mutual funds, a large pool of money from investors used to purchase many different securities. The biggest reason people invest in mutual funds is that they can enjoy the safety derived from investing in hundreds of different financial instruments, without having to buy each of those hundreds of investments themselves. So, diversification is the key component behind mutual funds.
Why is diversification so important?
Diversification is important because it helps us reduce risk when investing. There will always be a certain degree of risk in investment, but diversification helps us minimize risk. By investing in all different sorts of investments, your portfolio won’t be immensely affected overnight.
This is a bizarre example, but let’s say some aliens came down and fired an EMP wave on the entire West Coast of the US, rendering all electronic devices useless. Granted, there are bigger problems at hand, but let’s look at how this scenario might affect investors with varying degrees of diversification. Billy has invested only in FAANG stocks, namely Facebook (FB), Apple (APPL), Amazon (AMZN), Netflix (NFLX), and Alphabet/Google (GOOG). All of the FAANG company headquarters are on the West Coast and have been compromised. Investors are jumping ship, rightfully speculating failure. Stock prices for all of FAANG drop 90%, and Billy’s portfolio plummets from $10,000 to $1000 overnight.
On the other hand, John has been keeping up with Financial Literacy Journal articles, and has been diversifying his portfolio ever since. He is invested in FAANG, but also in stocks outside the tech industry. John is ready for a recession since he has invested in the Consumer Staples sector, as well as stocks that have proved strong performance in recessions, such as McDonald’s (MCD) or Dollar Tree (DLTR). John loses some from his FAANG investments, but also gains from his other investments.
As you can see from this simplified model, Billy’s undiversified portfolio suffers, whereas John’s diverse portfolio is healthier following the alien attack.
Suppose Jimmy, like Billy, has an undiversified portfolio. However, instead of FAANG stocks, he’s put his funds into a triple-leveraged oil ETF, greatly magnifying both his profits and his losses if the price of one barrel of oil increases or decreases, respectively. One day, OPEC decides to cut oil supply in half, greatly increasing the price of oil. Jimmy’s profits soar, and his returns are magnificent.
Although Jimmy took an undiversified approach, he still made more than a diversified portfolio. Why? Diversified portfolios limit risk, and limited risk translates into limited potential returns. Jimmy’s one-equity portfolio, incredibly riskier, potentially multiplies his profits.
It may seem that the greatest returns should be the main goal. This is not the case for the risk-averse investor. If OPEC instead decides to increase the supply of oil, oil prices will fall, and Jimmy will have lost a great deal of money. Additionally, in the long run, Jimmy’s portfolio will be subject to wild price swings and volatility.
There is no such thing as an investment without risk; however, different investments will have different risks. The takeaway is this: when you diversify your portfolio, you are essentially taking a whole bunch of different risks that offset each other in order to provide stability to your investments. Failure to diversify your portfolio means you are taking the same risks – putting your eggs all in one basket – meaning you could potentially lose everything.