What is Diversification?
Diversification is an approach to investing which involves the idea of offsetting the risk of individual securities or assets. Typically, this would mean creating a portfolio consisting of a number of assets/securities in order to reduce the risk and volatility of each investment.
The idea is that if one investment fails, then you would lose all of your money in that one asset. If you had a number of assets, then your money is spread, and the risk of each asset is considered to be less on the overall portfolio. There is also the argument that it will lead to greater longer-term returns as you aren’t relying on just one investment.
Diversification can be achieved in a number of ways and is typically given as common advice to all investors to help maximise their risk/reward payoff. A truly diversified portfolio consists of uncorrelated assets which can provide the highest returns with the least amount of volatility.
An example of diversification:
Two examples of portfolios: One showing no diversification, with all the investment put into one single asset, whilst the other shows a variety of assets within a single portfolio. Whilst the portfolios are extremely simplified, they exhibit the basic idea of diversification.
Portfolio A: A single asset within a portfolio. This one asset carries all the risk and leaves the investor vulnerable to losing all their investment if it fails. When it comes to rewards, the investor is only receiving rewards from that single security.
Portfolio B: A portfolio containing 5 different assets. The invested capital is spread equally across each of the 5 assets. The idea being that if one asset fails, the investor still has the other 4 assets to fall back on.
Why you should diversify:
The simple answer is that diversification lowers risk. Each individual security you invest in has risks associated with it. Diversification eliminates the risk specifically related to the individual company. Investing into a number of assets means that all your money is not tied up in one single area. It ensures if one individual asset is subject to failure because of company/industry specific risk then the other assets will support that portfolio.
Whilst diversification does have its critics, it really does make investing available to all. The fact is, when investing it is difficult to beat the market. The amount of research and knowledge required to choose one specific company makes it extremely problematic for the regular investor to outperform a diversified market. Whilst there are no guarantees, diversification supports the average person in creating a portfolio which can see positive returns as they offset the individual risk of their overall holdings.
Additionally, it is typically advised that those of you who are unsure on your investments should consider diversification. If you aren’t completely convinced that your individual securities will be a success, then holding a number of assets will help eliminate some of that risk, and ensure it is spread across the portfolio.
Does diversification work?
The theory shows that diversification of investments does reduce risk. Modern portfolio theory suggests choosing a number of assets helps to eliminate unsystematic risk – the risk specific to an individual security. Whilst risk directly associated to an individual asset cannot be completely removed, it can be diversified away.
As you can see from the graph, as you increase your assets, the risk does become lower. Although it must be considered that there are only so many assets which you can have in your portfolio to reduce risk, eventually it will level out and extra assets won’t have any effect on the risk.
There also remains systematic risk. This shows that whilst risk can be reduced, there is always a chance that something can affect your portfolio. It means that even with diversification, investments are always susceptible to market influences. To create an efficiently diversified, the assets which correlate the least create the greatest balance to reduce overall portfolio risk.
The reality of diversification is slightly more complicated. The theory is typically supported by following the stock markets, which show diversification does work. The stock market typically grows year on year, showing that a diversified portfolio leads to consistent yields. Using the S&P 500, you would see a positive return from following those 500 companies, with years of data to back up that theory. Additionally, funds tend to perform better than choosing a portfolio of individual stocks, suggesting that diversification really does benefit investors.
However, it is possible that diversification may not help maximise the risk/return payoff. There are arguments that diversifying for the sake of it is not always effective. This is because you could be buying more individual securities than is necessary. There is the suggestion that if you are keen on investing and have a wealth of knowledge then focusing on one specific company may be more suited to you. The idea being to have a greater concentration around that one individual security. As you have a greater understanding, then you will know if that company will grow, and there is the idea that you should go all in on it to maximise your returns.
However, diversification does reduce risk. Also, there are positive results within diversified portfolios, and you should consider it when you create your investment portfolio. It could be an important strategy for managing risk which you can use on your investing journey.
How you could diversify:
To diversify means that your investments should be different. Therefore, you should be aiming to ensure that there you invest in a number of different assets and securities to create the lowest risk for your overall portfolio. The ideal diversification of assets is to have those which hold no correlation to each other. If assets are unrelated, then they hold only risk which is specific to their individual company or industry. Some ways you could diversify:
Diversification of the investments you choose would mean they are not all susceptible to the risk of one major threat. Investing your money in different assets means that the volatility of each asset is reduced. For example, holding stocks and bonds would create a more diversified investment portfolio. Whilst stocks have larger returns, they are subject to larger fluctuations. On the other hand, bonds tend to be much steadier. Therefore they would stabilise the portfolio if the stock market was showing negative returns that year. There are many types of investments, which you may want to check out here if you wish to learn more about what you could invest in.
When investing within a country and its markets, you may want to diversify to ensure economic factors don’t affect your investments too much. For example, there may be political unrest within a country which could bring down all the investments within it. If you spread your investments across multiple countries or markets then there is less chance of one disruption ruining your whole portfolio.
Diversifying into different industries means individual stocks are at different risks. If all your stocks came from one industry, or matching industries then they would all be affected. For example, if the travel industry was brought to a halt, then stocks in air travel, hotels, cruise companies and more would all be affected, even though they are completely different businesses. Therefore, it is important to choose shares which won’t have an effect on each to efficiently reduce the unsystematic risk.
Diversification is an extremely useful strategy when it comes to investing. Diversification creates the ability to lower risk. There is both theory and evidence that back up the use of diversification when building a portfolio. Of course, you don’t have to diversify if it doesn’t match your ideal risk/reward pay off.
However, when you invest, you should consider diversification as you build your portfolio. Whilst diversification is not perfect, the ability to reduce risk is something every investor should be aiming to achieve. For the average investor, there are many elements they may be unaware of. Diversification can create that safety net within your investments. The ability to manage that risk whilst maintaining individual securities can really help to maximise the risk/reward payoff.