Along with every investment comes not only opportunity for gains, but also risks. A few major ones are:
- The risk of losing money.
- With price volatility, your investment may not be available at a value that's acceptable to you when you need it.
- The emotional toll that the fear of losing money and volatility can take -- and the possibility that fear or exuberance could cause you to sell or buy at the wrong time
Wherever a particular investment or group of investments is subject to the same possible negative event, you can diversify away from that group of investments to minimize that risk.
Here are a few examples of different kinds of diversification and how they can reduce risk.
Suppose you invested your entire life savings into Domino's Pizza stock. If the company were to be bankrupted by an accounting scandal, driven into the ground by competitors, or simply fail to grow at the rate investors expect and demand, you'd be out of luck.
You could limit the potential damage of risks specific to a single investment by choosing multiple investments.
Suppose instead that you invested all of your money in Domino's, Papa John's, and Yum! Brands (proud corporate owner of Pizza Hut). Now you'd be better protected from risks to Domino's, but you'd still be vulnerable to risks to the pizza industry. Maybe fierce pizza competition will force each of your companies to become less profitable; maybe health-conscious customers will gradually move away from pizza; maybe less rainfall permanently increases the costs of meat and cheese. To avoid such industry-specific risks, you can invest in multiple industries.
It's not always clear when you don't have diversification across different kinds of businesses. You might own pizza, soda, jewelry, cosmetic, and clothing stocks. Even though these are different industries, they're all consumer-based. An event that reduces consumer spending could affect all of them.
Stocks of certain sized companies can perform differently from other sized companies over fairly long periods of time. So many investors allocate some money to groups of small (say, $300 million to $2 billion in market cap), medium-sized ($2 billion to $10 billion), and large ($10 billion and up) each.
Economic downturns, currency fluctuations, political instability are all risks that can affect a single country. Many investors try to spread their investments across different countries and regions.
Certain strategies -- whether value, growth, or dividend investing -- can be more successful than others over periods of time.
Finally, different kinds of assets can have different return characteristics based on factors like economic activity, interest rates, inflation, or their relative valuations. Bonds, for example, tend to be less volatile than stocks, which makes them popular with retirees who may not have the option of waiting out a drawn-out stock market decline.
For these reasons, many investors try to spread their investments between stocks, bonds, real estate, (and sometimes even commodities).
Disadvantages of diversification
Some amount of diversification is pretty much universally advised to reduce the risks of losing money, volatility, and emotional stress. But just as diversification can limit your downside by averaging out risk and volatility across a group of investments, it can also limit your upside. As your level of diversification increases, your returns will be more likely to mimic the market average.
It's also possible for diversification to increase your risk if it leads you to purchase investments that are risky or that you don't understand very well. For example, an investor who lacks exposure to pharmaceutical companies, gold miners, hedge funds, or emerging market economies and knows nothing about these (risky) fields, might make a mistake by investing in them purely for the sake of diversification.
A highly diversified portfolio can also be more time-consuming to manage than a less-diversified portfolio because you'll have more investments to follow and trade, plus more layers of diversification to make sure you're adhering to. Transaction costs could also be higher if maintaining your diversification requires you to micromanage and trade more frequently.
Finally, while diversification can reduce risk, volatility, and heartburn better than non-diversification, it doesn't always work as well as hoped. During the 2008-2009 financial crisis, for instance, pretty much every stock fell substantially, and asset classes that had historically performed differently from each other moved in tandem. The relative inefficacy of diversification during financial crises can come as a shock.
The key is to find the right level of diversification for you.
Ways (and how much) to diversify
For people who invest in individual stocks, 20 or so well-diversified names can be enough to provide enough diversification without becoming a managerial hassle or diluting your returns.
You can achieve even broader diversification without picking your own stocks or bonds by investing in index funds, exchange-traded funds, or actively managed mutual funds.
As far as asset allocation goes, a simple 60-40 stock-bond mix is an appropriate choice for many people.
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