If you owned a fruit stand and you only sold oranges, then you would be in a bad spot if a hurricane wiped out all of the orange groves that you get your fruit from. However, if you sold a bunch of different fruits alongside oranges like bananas, apples, and berries, then you would still be able to make money when you couldn’t get oranges to sell. You could also use different fruit suppliers so that if something were to happen to the fruit crops in one place you would still be able to get fruit to sell from one of your other suppliers. This is a simple example of the concept of diversification.
Over the past month, I’ve talked about not trying to pick individual stocks or invest in crypto currency if you don’t have a solid financial foundation in place. Last week, I mentioned that a well-diversified investment portfolio is one of the cornerstones of a solid financial foundation. I realize that I haven’t done a good job of explaining why most of us shouldn’t be betting on individual stocks or crypto currency and why holding a diverse portfolio is important.
To start understanding the importance of diversification, you can replace “oranges” in the example above with the name of a stock that you’ve been thinking about investing in. It would probably hurt a lot if some bad news were to come out about the only stock that you have all of your money in and the price started tanking. If you held a bunch of different stocks, then that impact would hurt less.
I’m not going to go into a deep post about portfolio construction, Modern Portfolio Theory, etc. I’m going to keep this at a high level to hopefully get the point across of why we should practice diversification in our investments.
Don’t Put All Your Eggs In One Basket
Have you ever taken the time to think about what the saying, “Don’t put all your eggs in one basket” actually means? When I think of this saying, I imagine a little kid running back excitedly from the chicken coop after having gathered the fresh eggs for the day to take to his mom. However, on his way back he trips on something in the yard which sends his basket flying and all of his eggs come crashing to the ground and break.
He may have been able to save some of the eggs if he hadn’t been carrying them all in one basket or if he had taken multiple trips. That’s the idea behind diversification.
Individual stocks are risky. Anything could happen to a company and/or bad news could come out about it at any point. If you put all of your money into one stock (or any other investment), then you could lose everything. There’s always the chance (no matter how large or small) that a stock’s price could go to $0.
Don’t put all of your eggs into one basket. Diversifying your portfolio reduces your risk of something like this happening and having a significant impact on you. Instead of having to try and guess which individual company is going to outperform and which companies will not, you can hold all of them which allows you to have exposure to the outperformers without having to try and guess.
Different Ways To Diversify
Diversification doesn’t only mean holding a bunch of different stocks. That’s just an easy place to start to help build the foundation for the concept.
Here is a simple (not all inclusive) list of ways that you can diversify your portfolio:
Overall Portfolio
- Hold stocks, bonds, and cash
- Buy baskets of investments (mutual funds and ETFs) that diversify for you instead of only holding individual securities
Stocks
- Own large, medium, and small companies
- Own companies from all sectors of the economy
- Own growth companies and value companies
- Own domestic and international companies
Bonds
- Hold short and long-term bonds
- Hold domestic and international bonds
- Hold corporate bonds and government debt
- Hold bonds with high credit ratings and lower credit ratings
Diversify With Mutual Funds And ETFs
Concentration in an individual investment can be advantageous when a stock’s price is skyrocketing (which you’ll hear about in the media often and from your friends who own it) but extremely risky if something happens and the stock’s price rapidly declines (which your friends aren’t going to tell you about and the media won’t cover like they do the outperformers).
There are two sides to every coin but in this case diversification is a way to help you control your outcomes. As a financial advisor, maintaining diversified portfolios for clients means always having to say “I’m sorry” because parts of their portfolio will not be performing as well as others due to the nature of diversification.
Mutual funds and ETFs pool together investors’ money to invest in baskets of securities. This means that you get to hold tons of different stocks, bonds, and other assets in a security with the same or less investment than you would have to make to buy an individual stock. Purchasing one share of a mutual fund or ETF can be much less expensive and much more cost-effective than purchasing individual securities. If bad news were to happen to an individual stock within that portfolio, then it would have a much less dramatic effect on the whole portfolio than if you only held that one stock by itself.
There are all kinds of different mutual funds and ETFs to help you diversify your holdings into all of the categories that I listed above plus more. These types of investments allow you to create a diverse portfolio for the same price (or even less) than it would cost for you to purchase one single share of stock. You can even purchase “target-date funds” which take care of making sure that your portfolio is diversified all along your investment horizon.
Diversification Can Help You Control Your Emotions & Behaviors
A ton of success in investing comes from being able to control your emotions and behaviors. Holding a basket of stocks where the prices may not move as much in a short time span as an individual security helps many people to better manage their emotions. If you hold one stock or one crypto asset and it starts on a sharp decline because some bad news came out about it, then you may end up allowing your emotions to take over and selling it at the wrong time.
However, if you held a much more diversified portfolio which held that asset as well as a lot of others, then the bad news about that individual security wouldn’t have as much of an impact on your investment and you’d not worry as much. Time in the market is better than trying to time the market over the long run. Holding a diversified portfolio helps many people stick to their strategy and stay in the market when times are tough and their emotions are telling them otherwise.
Diversification Has A Lot Of Benefits
I could nerd out and write so much more about the benefits of why we should practice portfolio diversification, but I hope that this has given you at least a basic understanding.
