Welcome back to The Beginner’s Guide to Investing! This is Part 6 of the series, and we’re diving deep on the concept of diversification. In its simplest form, diversification can be summed up by the phrase “don’t put all your eggs in one basket.” The concept of diversification is critical to understand for a sound investment strategy, and can be applied across investment types and within mutual funds you may decide to invest in.
What is diversification?
Diversification is the idea of building an investment portfolio that includes different types of investments, rather than say, just Apple stock. The main goal of diversification is to reduce the overall risk of your investments while maximizing your return, by spreading out your investments across different asset classes, such as stocks, bonds, and mutual funds. The idea is that each asset class and investment type will react differently to the same event, and the underperformance of one investment can be offset by the over-performance of another.
Why is it Important?
Diversification can help mitigate and reduce risk, plain and simple. While it is never a guarantee, this strategy is tried and true, and many financial advisors and investment professionals follow it. A diversified investment portfolio is arguably the most important investment tool to reach long-term financial goals, like retirement.
Let’s look at an example. During the recent COVID-19 pandemic, the travel industry has been hit pretty hard, and as a result, many companies that provide hotels, air travel, anything travel-related have suffered. Their stock prices are significantly lower compared to before the pandemic, which is due to uncertainty in the industry and how companies will recover. As a result, if an investor had only bought stocks in travel-related companies, they’d have lost a ton of money due to economic uncertainty and circumstances beyond their control. Pretty scary and it’s a lesson to be learned on diversification!
How You Can Diversify
Diversification can be achieved in a variety of ways, whether it be through choosing investments in different industries and geographies, or through different asset classes like stocks, bonds, or mutual funds.
Different asset classes perform differently in different economic situations, and given different events and circumstances. For example, in a volatile market where stock prices fluctuate, bonds are generally considered a “safer” asset, as their returns tend to be steadier. Or, if you were to look at an index or mutual fund, which is essentially a “basket” of different stocks, you may find that some stocks perform better while others do poorly. Diversification amongst asset classes is critical, so explore different options and see what is right for your financial situation and risk tolerance.
Industry and geography is important as well. Looking at industries, different sectors perform better or worse due to a variety of world or economic events. As mentioned in the earlier example, COVID-19 has totally wreaked havoc on the travel and airline industries. But, the online tele-communication and technology industries are booming. So if you had investments across both, their performance would offset and help even out your return and lower your risk of loss.
A well diversified investment portfolio is an excellent tool to help mitigate risk and reach long-term financial goals. However, remember that even if your portfolio is well-diversified, you can never eliminate investment risk. The goal is to find a happy medium between mitigating and reducing risk, while also achieving a solid return.