What is Diversification?
Diversification is a method of portfolio management whereby an investor reduces the volatility (and thus risk) of his or her portfolio by holding a variety of different investments that have low correlations with each other.
How does Diversification work?
The basic idea behind diversification is that the good performance of some investments balances or outweighs the negative performance of other investments. For example, let’s assume that you work for Company XYZ--a beverage company--and you have $1 million to invest. Let’s further assume that you could invest all $1 million in your employer’s stock, or you could invest 50% in your employer’s stock and 50% in Company ABC, a healthcare stock.
If you invest all $1 million in Company XYZ stock, and the stock goes from $4 to $2 per share, your portfolio loses 50% of its value and you end up with $500,000.
Now let’s assume that you invested $500,000 in Company XYZ stock and $500,000 in Company ABC stock. The Company XYZ stock then goes from $4 to $2 but the Company ABC stock, which has very little in common with the Company XYZ stock in terms of factors that affect its price, goes from $6 to $7.50. The result is that $500,000 of your initial investment is now worth only $250,000 (this is the part invested in Company XYZ stock, which lost 50% of its value) but the other $500,000 is now worth $625,000 (this is the part invested in Company ABC stock, which rose by 25%). In this scenario, the portfolio goes from $1 million to $875,000. Still a loss, but not as bad as the $500,000 loss you would have suffered by putting everything in Company XYZ stock.
The big catch with diversification is that to do it well, the securities in the portfolio need to not “move together.” That is, the less correlated they are, the better. For example, if you invested everything in six different bank stocks, it’s fair to assume that what affects one bank stock probably affects the other bank stocks in your portfolio to some degree. Even though you’ve spread your money over several securities, you still suffer when one of your bank stocks has bad news. If you instead purchased a bank stock, a grocery stock, and a healthcare stock, you’d be investing in stocks that are less correlated with each other--that is, what affects one doesn’t necessarily affect the other. This diversification is great, but because they’re all stocks, any news that affects the stock market as a whole (say, an announcement about jobs) affects all of your stocks to some degree, no matter what industry they’re from.
This is why many investors go one step further and diversify across different asset classes. Stocks, bonds, and real estate are common asset classes. One common move is to invest in both stocks and bonds, because the stock and bond markets are historically negatively correlated, meaning that when the stock market is up the bond market is usually down and vice versa. Real estate and foreign stocks are also used to diversify portfolios.
Figuring out how to diversify across asset classes is what drives the practice of asset allocation. For example, an investor might choose to invest 20% of his portfolio in bonds, 70% in stocks, and 10% in real estate; but another investor, with different needs and expectations, might choose a different weighting. Determining the appropriate classes weightings for a particular investor is the essence of asset allocation as a method to optimize diversification.
Why does Diversification matter?
In our example above, you can see the difference that diversifying into just one other stock made. If you had invested in two more or three more stocks, the results may have been even better. However, there is no need to get carried away by trying to make a thousand different investments in a portfolio. That would be expensive and time-consuming, and you may not be able to take meaningful positions by dividing your money up into such small chunks. This is one reason that mutual funds and exchange-traded funds are popular--they offer an automatic basket of securities to the investor, although most experts agree that 25-30 stocks is enough to diversify a stock portfolio in a cost-effective manner (remember, buying and selling stocks incurs commissions).
Diversification does not guarantee millions in riches, but it does reduce risk. It’s one of the most fundamental, important investment concepts--one of the first pieces of investment advice most people get. One only needs to think about the Enron employees who placed all of their 401(k) savings in Enron stock to understand why failing to diversify is like betting the ranch on one roll of the dice.