How Does Diversification Protect Investors?

Perhaps you’ve heard that portfolio diversification helps protect investors from risk. If so, are you wondering how diversification protects investors?

For starters, we need to understand what we mean by diversifying our portfolio to hedge against risk. Diversifying your portfolio simply means investing in a variety of different types of assets.

Two Different Types of Risk

When you invest in a financial asset, you take on risk. This may sound like a bad thing. But it isn’t. Because without risk, there would be virtually no reward.

The more risk we take on when investing, the higher the potential return we have in the long run. Unfortunately, the greater the potential loss we face as well. That’s why it’s so important for investors to diversify to protect against risk.

When investing, there are two principle types of risk: systematic risk and unsystematic risk. Unfortunately, you can deal with the latter only through diversification.

Systematic risk is risk that affects the entire market. It is not limited to a specific company, market sector, financial instrument or even country. A great example would be the economic collapse the world is facing as a result of the current coronavirus pandemic.

Virtually all investments and portfolios are being affected by the current coronavirus. An unexpected event like this that slams the markets is often called a black swan event. This is the type of risk any investor must accept when investing in an asset.

On the other hand, unsystematic is less global and more local. It is the risk you accept when you invest in a particular company, sector, geographic region or asset class.

Because of this, unsystematic risk can be lowered through diversifying in different investments and asset classes. Let’s take a deeper look at how this works.

Diversifying Your Stock Portfolio

Consider investing all of your money in one stock – say, Amazon – versus investing your money in 30 different stocks. Amazon might seem like a great stock to buy. But if calamity strikes the company and it loses most of its value – which is always possible – you’ve just lost most of your money.

However, if you have only a portion of your money in Amazon and have the rest of your portfolio in 29 other stocks, you will be protected from most of these losses. While your position in Amazon will decline, the rest of the stocks may not. In fact, many of them may increase in value at the same time.

Investing in a portfolio of different stocks is one way to diversify. But it is far from the only way. Consider this: You own 30 different stocks, but all of them are in the same sector. Let’s say that the sector is banking.

You will definitely be protected against some risk. Let’s say that one of the stocks you own is Bank of America. Bank of America suddenly has a financial crisis due to trading in heavily leveraged assets and melts down. It goes out of business.

By owning 29 other stocks in the financial industry, you will be somewhat protected against the meltdown of Bank of America.  

Other Ways to Diversify Stocks to Lower Your Risk

But what if the meltdown wasn’t simply limited to Bank of America? What if it affected all of the major banks – like the meltdown the United States experienced at the onset of the Great Recession.

Now multiple banks go out of business. And most of the other bank stocks you own take a huge hit. Because all of your stocks were bank stocks, you are going to lose a massive amount of the total value of your portfolio.

But let’s say only two of your stocks were bank stocks. And the rest were spread out across other sectors and industries: healthcare, consumer goods, information technology, retail, manufacturing and more.

Even if the banking industry melted down, the rest of the stocks in your portfolio would likely be affected to a lesser degree because they are not financial stocks. They were not directly affected by the meltdown in that industry. This is why it is so important to invest in stocks across different industries.

You can diversify your stock portfolio even further. In addition to investing in many different stocks and stocks across different industries, you can also diversify across large cap, midcap and small cap stocks. You can diversify into growth versus value stocks. And you can even diversify into stocks in foreign markets.

Further Asset Allocation

The more you can diversify your stock portfolio, the better protected you will be against risk. But this leads to another question: What if the entire stock market crashes, as it did just recently?

If you invest all of your money in the stock market, this is going to be a significant problem. When the stock market crashes, most of your stocks will go down in value. Sometimes by a lot. Is there a way to protect yourself against this through portfolio diversification?

The answer is a resounding yes. You can do so by allocating some of your money into assets beyond stocks. Other assets you can allocate your money toward include government bonds, corporate bonds, commodities and precious metals like gold, real estate and more.

Some people even invest in art!

How does diversification protect investors against risk when you allocate your money to different asset classes? It does so because the increase and decrease in value of one asset class is not perfectly correlated with another.  In fact, sometimes they are inversely correlated.

For example, it is often the case that when stocks go down, the prices of bonds go up. This is because most bonds are less risky than stocks. When the stock market is not doing well, there tends to be a flight into the safety of bonds, which drives the prices of bonds up.

By keeping your portfolio allocated among these different types of asset classes – including keeping some money in cash or cash equivalents – you can minimize the amount of downside risk you take on in a bear market while still thriving during a bull market.

Are There Downsides to Diversifying to Protect Investors?

The short answer is yes… and no.

It can be argued that there are two major downsides to diversifying your portfolio:

1. Diversifying takes a lot more time, effort and work
2. It can hurt your total return

Diversifying used to be much more difficult for the average investor. This is because they would have to understand research a whole bunch of individual stocks, bonds and more.

But this is far from the case now. Many mutual funds and ETFs available on the market make it simple to diversify your portfolio with a minimal amount of effort.

So downside one is really no longer an excuse to avoid diversifying. But what about downside two?

There is a kernel of truth to this. Let’s say there are two stocks, Stock A and Stock B. They both trade at $100 per share and you can buy up to 10 total shares.

Now, let’s also say that over the next year, Stock A soars to $200 per share but Stock B climbs to only $110.

You argue that investing all of your money in Stock A was the better move. It earned you a much higher return than buying five shares of each and diversifying. Fair enough.

The problem with this thinking is that the risk you take on by buying only Stock A is unacceptably high for virtually any investor. After all, what if, due to some unforeseen event, instead of climbing to $200 the company went bankrupt and the stock went to $0.

If you invested all of your money in Stock A, you’d now be flat broke. But if you had put half in Stock B, and Stock B still went to $110, you’d have $550, which is much better than being flat broke.

So neither argument is a great one against the principle of stock diversification.

Concluding Thoughts on Diversification to Protect Against Risk

Hopefully you now have a much better understanding of the answer to the question how does diversification protect investors. It does so by spreading your money around different assets so that no one loss is too great for your overall portfolio.

Now, which assets should you diversify into? Picking stocks, bonds and other assets is a whole other ballgame. Luckily, we’re here to help. Investment U offers a free daily e-letter that delivers you investment ideas and opportunities straight from the minds of some of the world’s greatest investors.

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