Invest with Confidence: The Power of Diversification

woman diversifying investments

If you are new to managing your finances, it may be daunting at first.  The industry is teeming with complex terminology, making it less than straightforward.  However, rest assured that it’s achievable and less complicated than you might imagine.  There are a couple of important concepts to understand when it comes to managing investments.  Last week we reviewed asset allocation and today I will cover diversification.  In this post, I will discuss what diversification is, why it matters, and how to implement it.  Understanding this important concept will go a long way to making you a better investor.

What Is Diversification?

At its core, diversification is following the adage: don’t put all your eggs in one basket.  If you invest all your money in one company, and then that company goes out of business, you lose all your money.  Think back to companies like Enron or Lehman Brothers.  They went from being stable, successful companies to being out of business virtually overnight.  If you spread your investment across dozens, or even hundreds of companies, the likelihood they all go out of business (or perform terribly) at the same time is considerably lower. 

Why Does Diversification Matter?

The reason that diversification is so important is that it reduces the risk of investing.  You are still able to benefit from company growth, but you significantly reduce your risk by spreading your funds across several companies.  Not only is it unlikely that all the companies you invest in will go out of business, it is also less likely that different sectors of the market will drop at the same time.  For example, you may like investing in technology companies like Microsoft, Google, and Apple because they have done well in recent years, or you work in that industry and are more familiar/comfortable with it.  You may think by spreading your investments across twenty Tech companies you are diversified.  And while that is certainly better than investing in only one Tech company, you are not really diversified.  For example, imagine a scenario where the government introduces new legislation that makes it harder for technology companies to do business and consequently causes their stock prices to drop.  That same legislation may not affect other industries (like healthcare or automotive) allowing those companies to continue to perform strongly.  By spreading your investments, you are reducing the risk of events that affect specific companies, specific industries, or specific geographies.

The Benefits of Diversification

Diversification is an important investing principle that will benefit you.  First, it lowers your risk.  The market fluctuates daily, but certain companies, industries, and geographies move differently.  By spreading out your investments you will see less impact from the ups and downs of any individual area.  This will lead to more stable and consistent returns over time.  Despite what seems like wild (daily) fluctuation, the overall US stock market averages a 10% return per year over time.  This has been consistent for decades!  Diversification also allows you to benefit from whatever is doing well over a period of time without being overly impacted by companies that aren’t performing as well.  It is impossible to predict what the best performing company in any year will be and it changes over time.  By spreading your investments, you will be able to get the benefit of whatever performs the best without undue risk.

Implementing Diversification

There are several ways to increase the diversification in your portfolio, including diversifying across:

  1. Asset Classes
  2. Geography
  3. Sectors

Asset classes are the various investment options including stocks, bonds, and real estate most commonly.  As I discussed in my last post, you will want to include both stocks and bonds as part of your asset allocation.  Additionally, it’s important to diversify geographically.  This is generally done by investing in both US and international companies.  Finally, you want to ensure that your investments are spread across different sectors or industries, such as healthcare and technology.

If your head is spinning at this point, do not worry.  It’s not as complicated as it seems to ensure that you have a diversified portfolio.  Mutual funds and ETFs were created to solve this problem for investors.  The fund (or ETF) invests in a broad basket of investments, depending on its strategy.  You as the investor just buy the fund (or ETF) and you get all the benefits of diversification without having to research and manage hundreds of individual investments.

Monitoring and Rebalancing

Like asset allocation, diversification is not something you can do once and then ignore forever.  Different segments of the market will grow differently and will cause your portfolio to drift away from your goals over time.  As part of your rebalancing strategy, you want to ensure that you reset both your overall risk and your diversification periodically. 

Common Pitfalls to Avoid

There are a couple of common mistakes I have seen investors make when trying to diversify.  The most common is not understanding what is in various funds they are investing in.  There are thousands of funds available in the market with hundreds, if not thousands, of different strategies.  While you don’t have to research every holding in a fund, you do need to understand the general strategy and how it fits in with your overall portfolio to avoid these pitfalls. 

More Funds Does Not Equal More Diversification

I have seen many portfolios over my career that are invested in dozens of funds.  But when I ask about the strategy, it’s clear there wasn’t one.  Funds were just accumulated over time based on recommendations from friends or colleagues or news about the performance of specific funds.  Often these funds overlap or exclude entire sectors of the market.  Have a goal before you start investing and then pick specific funds that meet specific needs in the portfolio.  You can build a well-diversified portfolio that matches your risk tolerance with just a handful of funds.  More does not mean better.

Different Fund Issuers Does Not Mean Different Investments

There are many companies that issue mutual funds with lots of different strategies.  But there are many similar strategies that many companies duplicate.  For example, all the major fund issuers have an S&P 500 ETF.  You may think that buying the Vanguard S&P 500 ETF and the Fidelity S&P 500 ETF is spreading out your investment dollar.  However, both funds are invested in the exact same thing: the 500 companies listed in the S&P index.  Buying both does not increase your diversification at all.  Again, it comes back to an understanding of what the funds/ETFs you choose are invested in.

What You Know Is Not Always Best

One common hinderance to proper diversification is bias.  This often comes in the form of home country bias, i.e., being more comfortable investing in companies that are domiciled in the same country you live in.  I have also seen this as an industry bias.  For example, if someone works in healthcare, they may be more comfortable investing in healthcare companies and ignore other segments of the market.  While it is easier to invest in what you are more familiar with, this leads to concentration that you are trying to avoid.  You want to ensure that you invest across asset classes, geographies and sectors as previously discussed, not just across areas you are most familiar with.

Diversification is Key

In addition to asset allocation, diversification is a key concept you need to understand if you are starting to manage your investments for the first time.   At its core, diversification is spreading your investments across many companies, industries, and geographies to reduce risk and smooth out your investment performance.  You can create a well-diversified portfolio with a handful of mutual funds or ETFs if you have a good understanding of your goal and the underlying holdings in the funds.  Managing your asset allocation and your diversification will go a long way towards making you a successful investor.

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