Investors all over the world are familiar with the saying, “Don’t put all your eggs in one basket,” which urges them not to put all of their money in one company, industry, or financial vehicle. Diversification is a basic lesson in investing, as it helps reduce unsystematic risks, protect portfolios, and reach long-range financial goals.
To illustrate: suppose your portfolio only contains a single company, which is in the energy sector. If that company reports loss of earnings at the end of the year, or the energy sector suddenly falters, the price of that company’s stock will drop. This will also drag down the value of your portfolio with it and you will suffer losses. But if you diversified into the healthcare sector, for instance, only part of your portfolio will be affected. The healthcare stock will counterbalance the energy stock, thus minimizing losses.
Diversification does not thoroughly guarantee against loss because of the presence of systematic or market risks like exchange rates, inflation rates, and political climate and instability. However, it can at least curb unsystematic risks specific to a particular company, industry, market, economy, or country.
How to diversify
Most investors think that investing in different types of companies is enough, but it is actually more advisable to diversify across the board—invest not only in multiple companies but in various industries as well. According to Investopedia, “The more uncorrelated your stocks are, the better.”
Investing in different asset classes is another way to diversify, as these classes do not react in the same way to given stimulus. Dubbed as asset allocation, it is the strategy of dividing investment portfolio across various asset classes like stocks, bonds, and money market securities. Asset allocation is popular among conservative investors as it balances risks and protects against major losses due to unprecedented events.
Typically, stocks fall within three classes: stocks, bonds, and cash. In general, bonds and equities move in opposite directions, so a portfolio with both of these assets will be able to offset unpleasant movements on one side with positive results in another. Subclasses include large-, mid-, and small-cap stocks, international securities, emerging markets, money markets, fixed income securities, and real estate investment trusts.
However, while the lesson of diversification is known to many, not all investors are aware of how to accomplish it without going overboard and losing the benefits that diversification has to offer.
It is important to remember that no matter how diversified a portfolio is, risks that affect overall economies are still inevitable. There is a debate over how many stocks are needed to reduce risk while maintaining high returns. Conventional investors advise 15 to 20 stocks spread across various industries.
These numbers are supported by the modern portfolio theory, which states that achieving optimal diversity is closest after adding the 20th stock in a portfolio. A portfolio of 20 stocks reduces risk to about 20 percent, but additional stocks to up to 1000 can only reduce risk by about 0.8 percent.
However, this does not suggest that 20 stocks equate with optimum diversification. This only means that one can reduce risks only up to a certain point at which there is no further benefit from diversification. There are still other factors at play aside from the number of stocks, such as company size, sector, industry, country, and the like.
As Warren Buffet said, “Wide diversification is only required when investors do not understand what they are doing.” If you diversify too much, you might not lose much, but you might not gain much either. The key is to find your portfolio’s balance between risk and return, as this will help you inch closer to your financial goals.
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