The technique of distributing investments among several industries, asset classes, and geographical areas in order to lower an investment portfolio’s overall risk is known as diversification. The theory is that by having a diverse portfolio, the underwhelming performance of one investment may be compensated for by the superior performance of another, resulting in a more steady total return. Therefore, the goal of diversification is to incorporate assets that are not closely tied to one another.

The majority of investing experts concur that diversification is the most crucial element in achieving long-term financial objectives while lowering risk, even though it does not ensure against loss. Here, we examine the reasons for this as well as strategies for achieving portfolio diversification.

What is Diversification in Investing?

Assume that all of the equities in your investment portfolio are airline stocks. Following negative news particular to the industry, like an indefinite pilot strike that finally results in flight cancellations, the share prices of all those stocks may fall simultaneously. This implies that the value of your portfolio will noticeably decline. These equities can be offset by a few railway stocks, so only a portion of your portfolio will be impacted. As travelers search for other ways to get about, there’s a significant probability that railroad stock prices will increase.

The core of diversification is the proactive balancing of your portfolio across various investments. When diversifying, you take a defensive stance rather than trying to optimize your returns by investing in the most lucrative businesses. The U.S. Securities and Exchange Commission actively promotes diversity as a strategy.

The primary components of diversity are as follows:

Diversifying Across Sectors and Industries

The example above of buying railroad stocks to protect against detrimental changes to the airline industry is diversifying within a sector or industry. In this case, an investor is interested in investing in the transportation sector and holds multiple positions within one industry.

You could diversify even further because of the risks associated with these companies. That’s because anything that affects travel in general will hurt both industries. This means you should consider diversifying outside the industry. For example, if consumers are less likely to travel, they may be more likely to stay home and consume streaming services (thereby boosting technology or media companies).

Diversifying Across Companies

Risk doesn’t necessarily have to be specific to an industry—it’s often present at a company-specific level. Imagine a company with a revolutionary leader. Should that leader leave the company or pass away, the company will be negatively affected. Risk specific to a company can occur from legislation, acts of nature, or consumer preference. As such, you might have your favorite airline that you personally choose to fly with, but if you’re a strong believer in the future of air travel, consider diversifying by acquiring shares of a different airline provider as well.

Diversifying Across Asset Classes

So far, we’ve only discussed stocks. However, different asset classes act differently based on broad macroeconomic conditions. For example, if the Federal Reserve raises interest rates, equity markets may still perform well due to the relative strength of the economy. However, rising rates push down bond prices. Therefore, investors often consider splitting their portfolios across a few different asset classes to protect against widespread financial risk.

More modern portfolio theory suggests also pulling in alternative assets, an emerging asset class that goes beyond investing in stocks and bonds. With the rise of digital technology and accessibility, investors can now easily put money into real estate, cryptocurrency, commodities, precious metals, and other assets. Again, each of these classes have different levers that dictate what makes them successful.

Diversifying Across Borders

Political, geopolitical, and international risks have worldwide impacts, especially regarding the policies of larger nations. However, different countries operating with different monetary policy will provide different opportunities and risk levels. For instance, imagine how a legislative change to U.S. corporate tax rates could negatively impact all entities within the U.S. For this reason, consider broadening your portfolio to include companies and holdings across different physical locations.

Diversifying Across Time Frames

When considering investments, think about the time frame in which they operate. For instance, a long-term bond often has a higher rate of return due to higher inherent risk, while a short-term investment is more liquid and yields less. An airline manufacturer may take several years to work through a single operating cycle, while your favorite retailer might post thousands of transactions using inventory acquired same-day. Real estate holdings may be locked into long-term lease agreements. In general, assets with longer time frames carry more risk but often may deliver higher returns to compensate for that risk.

10 Benefits of Investment Diversification

For good reason, diversification is an often advised financial strategy. Ten advantages of using a diversity strategy are as follows:

1. Risk Reduction: Diversifying across different asset classes and investments helps spread risk. If one investment underperforms, it may be offset by others that perform better.

2. Steadier Returns: Diversification can lead to more stable and predictable returns over time, reducing the impact of market volatility.

3. Minimized Portfolio Volatility: A diversified portfolio tends to have lower price fluctuations, which can help you sleep better at night, knowing your investments are not subject to extreme ups and downs.

4. Asset Protection: It safeguards your wealth from the specific risks associated with individual stocks or sectors. A downturn in one industry won’t have a catastrophic effect on your entire portfolio.

5. Liquidity: Diversification can ensure that you have investments that are relatively easy to convert to cash when needed, providing liquidity in emergencies.

6. Exposure to Different Opportunities: Diversification allows you to participate in various market opportunities, from growth stocks to value stocks, from emerging markets to established markets.

7. Reduced Emotional Decision-Making: It can prevent impulsive investment decisions based on emotions, as a diversified portfolio is less susceptible to the emotional rollercoaster of individual investments.

8. Alignment with Investment Goals: Diversification can be tailored to your specific financial goals, risk tolerance, and time horizon, ensuring your portfolio aligns with your objectives.

9. Reduced Concentration Risk: It minimizes the risk of having too much of your wealth tied to a single investment or a single sector. This is especially important when investing in individual stocks.

10. Enhanced Long-Term Performance: Over the long term, diversified portfolios have the potential to deliver more consistent and competitive returns, ultimately helping you grow your wealth steadily.

Read Also: Wealth Creation Through Passive Income Streams

It’s worth noting that diversification should be done thoughtfully, considering your unique financial situation and goals. The specific mix of assets in your diversified portfolio will depend on factors such as your risk tolerance, investment horizon, and market conditions. Regular portfolio review and rebalancing are essential to ensure that your diversification strategy remains aligned with your objectives.

How Many Stocks You Should Have

There is no magic number of stocks to hold to avoid losses. In addition, it is impossible to reduce all risks in a portfolio; there will always be some inherent risk to investing that can’t be diversified away.

There is discussion over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries. Other views contest that 30 different stocks are the ideal number of holdings. The Financial Industry Regulatory Authority (FINRA) states that diversification is specific to each individual and recommends considering the decision after consulting with an investment professional or using your own judgment.2

For investors who might not be able to afford holdings across 30 different companies or for traders who want to avoid the transaction fees of buying that many stocks, index funds are a great choice. By holding this single fund, you gain partial ownership in all underlying assets of the index, which often comprises dozens (if not hundreds) of different companies, securities, and holdings.

Different Types of Risk

Investors confront two main types of risk when they invest. The first is known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This category of risk isn’t specific to any company or industry, and it can’t be eliminated or reduced through diversification. It is a form of risk that all investors must accept.

The second type of risk is diversifiable or unsystematic. This risk is specific to a company, industry, market, economy, or country. The most common sources of unsystematic risk are business risk and financial risk. Because it is diversifiable, investors can reduce their exposure through diversification. Thus, the aim is to invest in various assets so they won’t all be affected the same way by market events.

Pros and Cons of Investment Diversification

Pros

Diversification attempts to protect against losses. This is especially important for older investors who need to preserve wealth toward the end of their professional careers. It is also important for retirees or individuals approaching retirement that may no longer have stable income; if they are relying on their portfolio to cover living expenses, it is crucial to consider risk over returns.

Diversification is thought to increase the risk-adjusted returns of a portfolio. This means investors earn greater returns when you factor in the risk they are taking. Investors may be more likely to make more money through riskier investments, but a risk-adjusted return is usually a measurement of efficiency to see how well an investor’s capital is being deployed.

Some may argue diversifying is important because it also creates better opportunities. In our example above, let’s say you invested in a streaming service to diversify away from transportation companies. Then the streaming company announces a major partnership and investment in content. Had you not been diversified across industries, you would have never reaped the benefit of positive changes across sectors.

For some, diversifying can make investing more fun. Instead of holding all your investment within a very narrow group, diversifying means researching new industries, comparing companies against each other, and emotionally buying into different industries.

Cons

Professionals are always touting the importance of diversification but there are some downsides to this strategy. First, it may be somewhat cumbersome to manage a diverse portfolio, especially if you have multiple holdings and investments. Modern portfolio trackers can help with reporting and summarizing your holdings, but it can often be cumbersome having to track a larger number of holdings. This also includes maintaining the purchase and sale information for tax reasons.

Diversification also can be expensive. Not all investment vehicles cost the same, so buying and selling will affect your bottom line—from transaction fees to brokerage charges. In addition, some brokerages may not offer specific asset classes you’re interested in holding. Note, however, that recent trends toward zero-commission trading in stocks and ETFs have greatly reduced the cost of putting together a well-diversified portfolio.

Also, consider how complicated diversified investing can be. For instance, many synthetic investment products have been created to accommodate investors’ risk tolerance levels. These products are often complex and aren’t meant for beginners or small investors. Those with limited investment experience and financial wherewithal may feel intimidated by the idea of diversifying their portfolio. Unfortunately, even the best analysis of a company and its financial statements can’t guarantee it won’t be a losing investment. Diversification won’t prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.

Finally, some risks simply can’t be diversified away. Consider the fallout from the COVID-19 pandemic in March 2020. Due to global uncertainty, stocks, bonds, and other classes all fell at the same time. Diversification might have mitigated some of those losses, but it can’t protect against a loss in general.

Pros

• Attempts to reduce risk across a portfolio
• Potentially increases the risk-adjusted rate of return for an investor
• Preserves capital, especially for retirees or older investors
• May garner better investing opportunities due to wider investing exposure
• May cause investing to be more fun and enjoyable, should investors like researching new opportunities

Cons

• Generally leads to lower portfolio-wide returns
• May cause investing to feel burdensome, requiring more management
• Can result in more and larger transaction fees
• Does not eliminate all types of risk within a portfolio
• May turn your attention away from large future winners
• May be intimidating for inexperienced investors not wanting to buy index funds

Diversification, however, also can have a negative impact on portfolio returns. When investors use diversification, they do not have a significant concentration in any one investment or industry sector in an attempt to capture idiosyncratic high returns. This is because a diversified portfolio is optimized to achieve the highest risk-adjusted returns, and not the highest absolute returns possible. Thus, diversification may cause an investor to miss out on the potential high returns of a specific stock, asset class, or market segment that is outperforming.

Final Thoughts

Diversification can help an individual investor manage risk and reduce the volatility of an asset’s price movements. Remember, however, that no matter how diversified your portfolio is, risk can never be eliminated completely. Moreover, diversification can result in missing out on company- or industry-specific above-average returns that may be captured by a more active monitoring but less-diversified approach.

However, if you aren’t a professional investor it is important that you seek to minimize the risk associated with owning individual stocks, while bearing in mind that general market risks affect nearly every stock. It is therefore important to diversify among different asset classes, geographical locations, security duration, and companies.

Only seek to concentrate your holdings once you have been in the market for a significant amount of time and are familiar with the potential risks you are exposing yourself to. The key is to find a happy medium between risk and return. This ensures you can achieve your financial goals while still getting a good night’s rest.