What is Diversification in Investing?
Take a look at any major fund portfolio or any seasoned investor’s holdings and you’ll find a broad smattering of investments. This can include different sectors, investment products, allocations and modes of investment. It’s an example of diversification: something every investor needs to be familiar with.
Diversification is the practice of entering funds or company activity into a variety of investments or markets, such as technology, real estate, etc. This can lower risk and allow for higher long-term returns. Above all, it’s vital in protecting your wealth from the downturn in any one area.
It’s not difficult to practice diversification. Variety is the spice of life, and there are a multitude of opportunities for hedged investing across different areas. The key to good diversification is to understand your allocations and to keep them balanced as you pursue wealth accumulation.
Examples of Diversification
There are many ways to practice diversification. It comes down to spreading investments out based on different variables, to hedge against disruptive forces affecting any one single variable. Some simple examples of diversification include:
- Asset. Spreading your holdings between stocks, bonds, ETFs, commodities, etc.
- Region. Holding investments from both foreign and domestic markets.
- Sector. Allocating holdings across multiple areas of industry and commerce.
- Metric. Choosing companies with different cap sizes and other fundamentals.
For example, an investor might allocate their portfolio holdings across five sectors. Or, they might spread their portfolio holdings out across stocks, bonds, commodities and cash. Even simple diversification is useful in hedging against volatility.
Diversification vs. Indexing
There’s often a question of diversification vs. indexing. In many ways, indexing is a form of diversification. Index funds—and mutual funds—represent a broad swath of investment types. This offers investors the diversification they’re looking for in a single package. Instead of building a portfolio with handpicked investments, investors can put their money into a diversified fund and reap the advantages. Indexing is a common tactic for diversification and offers access to broad market exposure.
Rebalancing to Maintain Diversity
Portfolio diversification is an ongoing effort. Different investments will perform at different levels and, over time, will gain or lose value at different rates. To reset your proportions, investors need to rebalance periodically. This means taking profits and locking in losses to restore portfolio diversity. It may also involve adding new holdings or divesting from others completely.
Portfolio rebalancing is something investors should consider annually, at a minimum. Quarterly rebalancing can also be beneficial for more hands-on investors. Note that many funds handle rebalancing as part of active management; investors don’t need to worry if they’re indexed.
The most prominent benefit is protection from sudden downturn in one area of the market. For example, an investor whose portfolio was heavily invested in the financial sector in 2008 saw their wealth evaporate overnight in the Great Recession. Moreover, cyclical industries can ebb and flow, causing exaggerated ups and downs if not offset by other investments. Diversification equates to stability, as a hedge against volatility.
It’s also proven to yield better returns as a result of hedging. Instead of banking on the performance of one or two sectors or investment products, diversification buoys the entire portfolio. The gains of some sectors offset the losses of others, and over time the gains generally outweigh the losses. Broad market exposure and diversification spread gains and losses more evenly across time.
Finally, it offers context for investment performance. Before rebalancing, it’s easy to measure portfolio investments against the broader performance of similar products. For example, if your Energy sector stocks are down 12% on the year but the energy sector itself is up 2%, it can inform the decision to rebalance. Likewise, it’s easy to see where your largest gains and losses are, and to weight a diversified portfolio accordingly.
While considered best practice for long-term investments, there are drawbacks to diversification. In the short term, it can limit gains from strong performers within a portfolio. For example, you may want to invest 100% in strong-performing telecom stocks, but split that investment for the sake of diversification. If telecom continues to boom and your diversified investments falter, it’s the opportunity cost of diversification.
There’s also the drawback of time management. Researching and investing in a diversified portfolio takes more time than investing in only sectors or products you understand—or even indexing. To see success, investors need to take the time to understand every investment, which isn’t always feasible.
Finally, diversification can conflict with individual investor theses. You may want to invest in one or two sectors specifically, or believe that a certain type of investment will perform better than the market average. Diversification contrasts these theories. It can force investors to shy away from strategies they believe in for the sake of hedging against risk. Where risk and reward are often equal, diversification automatically serves to diminish both.
Diversification is a Responsible Practice
Investors need to practice diversification to shield themselves against the ebb and flow of the market’s many individual companies and various sectors. While some investments ebb, others will flow. The result is healthy portfolio performance over time and the confidence that comes with balanced holdings.
Diversifying can also give you the ability to invest in trends without compromising your portfolio. To learn more, sign up for the Profit Trends e-letter below and gain access to daily stock tips and market movement.
Remember that diversification is an ongoing practice, as well. Pay attention to your holdings, learn from them and, when the time comes to rebalance, make smart decisions about how to restore a diversified balance to your holdings.