As early as childhood, people begin to learn the benefits of diversification. For investors, the concept of not putting all of your eggs in one basket is relatively easy to understand. Yet there are several different types of diversification to consider. While investors generally do a good job of identifying their most basic needs for different investments, they don't always succeed in eliminating the risk that comes with assets whose prices tend to move in similar directions. Let's examine a few different levels of investment diversification.
First level: single investments
The most basic application of diversification can be found in the portfolios of many beginning investors. When you start out with stock investing, you often don't have a large amount of money to invest initially. As a result, you face a dilemma: Should you take your small amount and divide it into even smaller amounts to buy multiple stocks, or should you put the full amount into a single company?
It's easy to understand that investing in a single stock carries both huge potential reward and huge risk. If you're lucky enough to find a great performer like Grupo Simec
The simple solution is to invest in more than one stock, even if you don't have a lot of money with which to invest. In a diversified portfolio of individual stocks, you will inevitably have some winners and some losers. As long as your winners do well enough to more than offset your losing stocks, then you will not only positive returns over the long haul but also a much smoother ride along the way.
Second level: asset classes
Once you have a number of stocks among your investment holdings, the need for diversification changes gears. Although owning multiple stocks protects you from the risks that individual companies face, there are other types of risks common to the stocks of most companies -- general economic conditions and the overall business and political environment, for example. Events such as economic recessions and rising price inflation tend to have similar effects on the stock prices of companies regardless of industry. Because all stocks bear the risk of these general events, there's no way to protect yourself from that risk simply by buying additional stocks.
Luckily, a number of different types of investments don't always behave in the same way. Bonds and other fixed-income securities sometimes move in the opposite direction from the stock market and thereby help to reduce the blow from market drops. Cash and similar short-term securities, such as Treasury bills, also act as a ballast to lessen the impact of violent price movements in other markets. With the advent of new financial products, investments in other types of assets, such as real estate and commodities, now provide yet another alternative method of adding diversification and stability to a portfolio. By strategically allocating assets among these various asset classes, you can protect yourself from the types of risk that can hurt even a large group of individual securities within the same asset class.
Third level: subclasses
Even within a broad class of investments, additional opportunities for diversification exist. For instance, while a wide selection of stocks of American companies may provide substantial protection against risks that individual companies face, adding certain stocks of international companies may allow you to profit in the event that the economies of foreign countries perform more strongly than the domestic economy does. If your portfolio focuses on large companies, adding exposure to some smaller companies may increase your returns and give you the ability to profit from more nimble and responsive businesses. Similarly, on the fixed-income side, many portfolios end up focusing on Treasury bonds, which provide safety and security. However, adding corporate bonds may help to improve your overall income yield, and adding international bonds can allow you to benefit from favorable currency movements and protect against the risk of rising interest rates within the United States.
As the number of available investments continues to rise, so, too, will the opportunities for investors to diversify their portfolios. However, it's also important to understand that some investment moves don't actually increase diversification.
Many mutual fund investors wrongly believe that by investing in two or more mutual funds, they increase the level of diversification in their portfolios. First, most stock mutual funds own dozens or even hundreds of individual stocks. As the number of stocks you own grows, the added benefits from diversification that you get from adding another stock to your portfolio become less significant. For instance, you might benefit greatly by increasing the number of stocks you hold from two to 20, but going from 100 to 200 may not have nearly as great an impact.
Second, many mutual funds own exactly the same securities. For example, if you own an S&P 500 index fund and a mutual fund that focuses on large-cap technology companies, the odds are that both of them will own big tech stocks such as Microsoft
Diversification is a simple concept. Used properly, it can help you avoid the sorts of catastrophic events that can destroy your financial plan. By being aware of the benefits of diversification, you can ensure that you take the necessary steps to protect yourself and minimize the risks that you face as an investor.
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Fool contributor Dan Caplinger diversifies his life as well as his portfolio. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy gives you certainty in an uncertain world.