Why should our investments be diversified?
If you are picking individual stocks this can result in you being exposed to too much risk. Especially if you are only invested in a single business sector or single region of the world. This means the performance of your investments are tied to that sector or country doing well.
In the worst case you’ve only invested in one single company. What if that company goes bankrupt, the sector starts to become irrelevant or the country has a civil war or natural disaster. All these things are incredibly difficult to predict but that’s why we diversify.
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What is diversification?
Diversification allows you to play all sides of the field so when some countries, sectors and big businesses have down years other companies can pick up the slack.
By diversifying your portfolio you are admitting that you can’t predict the future and you don’t know which companies will perform well in the coming years.
This may sound like a negative statement but it’s actually a very positive outlook. This is because it’s the truth. Not even the top investment companies in the world know what’s going to happen. I doubt anyone had a pandemic built into their investment performance.
How do you become diversified?
There are countless ways you can diversify your portfolio but here are a few of the main concepts.
Sector Diversification
If you’re starting with a small selection of domestic companies ensuring you expose yourself to different sectors can be very beneficial. Different sectors are focus on different ways of providing value and so gains to investors can vary considerably from sector to sector.
Some sectors like utilities historically don’t have too much stock market growth but instead distribute money through dividends. Technology companies are primarily invested in for their growth potential. By covering different sector areas you can gain from these different ways of making a profit.
You’ll also stop yourself from being solely invested in a sector which is declining, allowing you to get a good average return from multiple areas.
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Global Diversification
Now if you’re only invested in domestic stocks you could find value in looking internationally. There are many companies around the world which can give you plenty of returns.
The benefits of doing this is again to reduce volatility. If there’s a recession in your country a war or an epidemic all your investments will likely see a drop in value. These same issues may not be prevalent in other areas of the world hence your portfolio could still be in the green.
You also don’t know which country may do well in the next couple decades. The USA may not always be the provider of the biggest gains for people. Emerging markets may have their time to shine and if you invest globally you could be buying them relatively cheaply. Of course there is no way to know but even a small allocation could result in big gains if you’re a long term investor.
Asset Diversification
The final form of diversification is by asset. Most people focus on just buying stocks and shares however there are plenty of other forms of investment you can make. Some examples are property, commodities and bonds.
By having a percentage of your portfolio split between different assets you can help protect yourself when the stock market drops.
This method is used all over the world as you will have probably heard of 60/40 funds. Essentially these usually have 60% equities usually stocks and 40% bonds and other assets. This is again aimed to reduce volatility in your portfolio although this is not always the case and it can also reduce your overall returns as bonds don’t have the same potential for earnings as a share in a business.
This can work in your favour when getting closer to utilising your money as you can then maintain more stability in your wealth and use it as an income for instance when you retire.
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Performance and Diversification
Diversification is a difficult balance because you still want to get good performance. Obviously you don’t know where this performance will come from hence the wide range of companies in the first place.
This can mean you are not maximising your returns if you overexpose yourself to an underperforming asset or stock. The truth is however you will never be able to truly maximise your profits. Even if you just invest in the S&P 500 the primary gains over the past few years have been made by a few dominant companies (the magnificent 7).
Obviously if you just invested in these you would have been far better off than investing in the S&P 500. However these companies never remain at the top in fact just 20 years ago only Microsoft was in the top 10*. Who knows how long these companies will be able to maintain their dominance.
The idea with diversification is therefore not to maximise gains and beat the market but to ensure an average return with a little bit less volatility and crucially less stress.
In Summary
Diversification is a tool any investor can use to ensure they are exposed to lots of different companies to alleviate risk and target an average return over their investing career.
For DIY investors this is invaluable as you likely don’t have hundreds of hours to research individual companies to invest in. This makes it far simpler to invest especially when using ETFs which can provide you with this diversification in one purchase.
Thank you for reading and I hope you found this useful. Any comments feel free to write below. Happy diversifying!
Disclaimer
All information is not financial advice and is purely meant for educational purposes only. Investing involves the risk of loss of capital as well as its gain. Any investments mentioned on this website are meant as examples not specific recommendations. Always do your own research and/or gain the help of a financial advisor.
