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What is diversification?

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“Don’t put all your eggs in one basket”, a phrase we oftentimes hear that tells us not to invest all our resources into a single possibility. For instance, if you’re on the hunt for a job, filling out a single job application only would be putting all your eggs in one basket, instead of seizing the opportunity to fill multiple applications just in case.

Much like the job hunt analogy, when it comes to investing in stocks, putting all your eggs, or your hard-earned money in this case, in a single stock might be risky. While you may hit the jackpot and have the stock soar to record prices, you have just as much of a chance to see your stock plummet to rock bottom.

What is diversification?

You can think of diversification as an asset allocation strategy of simply splitting your eggs into different baskets. Instead of pooling all your money into a single type of investment, you can opt to diversify your portfolio by investing in different assets, companies, industries, or even countries. That way, even if one of your investments doesn’t do well, eggs in different baskets can hopefully stay intact. 

Diversification is best utilized when your investments are not affected by the same economic factors. For example, if you decide to invest in a farm land and a fertilizer stock, they may both be negatively affected by a decrease in demand for agricultural products. Accordingly, you will experience losses twice due to the same factor.

How can I diversify my portfolio?

You can choose to diversify your investment portfolio in different ways to mitigate different risks. Let’s look at some of these ways below:

Diversification through different asset classes 

If carrying eggs only in all your baskets is risky, you can choose to put apples, oranges and bananas in some of your baskets to reduce that risk. Think of the different groceries as the asset classes you choose to invest in. Even if the stock market crashes but you have still diversified your portfolio using different asset classes, your investments will be less affected by this drastic shock. Here are some examples of asset classes to consider for investments:

  • Stocks or equity – shares in a publicly-traded company
  • Bondsdebt securities with a fixed income issued by governments or corporates
  • Cash or cash equivalents – these include certificates of deposit and treasury bills
  • Physical assets – such as real estate, gold or artwork.
  • Cryptocurrencies – such as Bitcoin, Ethereum, Tether, etc.

Within each asset class, you could diversify your portfolio even further. Here are some of the strategies you can use to diversify your stock portfolio:

Diversification through different companies

This is exactly the “eggs in different baskets” example we were just talking about. Think of different baskets as different companies, where even if a certain company in which you own stock fails, your other baskets may still get you closer to the return on your investment you are seeking. One way through which you can invest in a basket of different companies is through Exchange-Traded Funds.

Diversification through different industries

What if people suddenly stopped buying white eggs, opting instead for brown eggs only? Think of different kinds of eggs as different industries of different companies. Some industries may face external shocks due to changes in laws, or even merely due to changing consumer preferences. By investing in different industries, and in turn having baskets of brown and white eggs, you reduce the risky effect of white eggs falling out of fashion.

Are there any downsides to diversification?

As much as diversification reduces your exposure to the risk of a falling stock price, it can also reduce your returns on a rising one, if you had invested in that stock alone. In other words, diversification is simply a trade-off between lower risk of losing money and a lower return on each stock

Is diversification a good strategy?

At the end of the day, there is simply no foolproof strategy in investing – it’s just a matter of how you balance between risk and reward. Diversification significantly reduces risks, so it accordingly decreases the potential of returns from a single asset. With that in mind, it is evident that diversification is an essential strategy that should be in your toolbox to use in the way you deem fit to the risk-reward balance you want your portfolio to have.