What is Diversification? What It Is and Why You Need It
Diversification is a fancy word in the investing vocabulary that basically means: “don’t put all your eggs in one basket”. But more importantly, it’s your winning strategy when it comes to your investment portfolio
If there’s one concept you should master when it comes to investing, it’s diversification. Diversification helps to minimise risk by spreading your investments across different types of securities, businesses, industries, regions and (or) countries. The logic follows that if you spread your risk, you ensure that your investment is not unified in one place and therefore removes the possibility of making complete losses on your investments. So let’s dive into what diversification is and how you can apply it to your own portfolio. Let’s go!
What is diversification?
When it comes to investing, diversification refers to a strategy adopted by investors to manage risk. Rather than pooling all of your money into a particular company or asset class, those who diversify focus on spreading out risk by allocating investments across different sectors, industries, and other categories so that you maximise your overall return.
The rationale behind this technique is to protect your portfolio from overall losses. Holding a range of assets, across different industries and sectors, is deemed to offer stronger, long-term returns.
Understanding diversification
Countless studies and mathematical models have shown that diversification is a winning strategy in offsetting risk exposure, and guaranteeing some form of protection against significant losses.
The idea is that you diversify by investing your money across different asset classes — such as stocks, bonds and private equity. Then you diversify within the different types that fall within the umbrella of a particular asset class. So let’s say you buy stocks, you buy across a range of different sectors such as tech, e-commerce and green energy.
Diversifying across industries and sectors
When pursuing a well diversified portfolio, a good rule of thumb is to invest in at least 10 companies. Anything from there is a bonus! This way, you have a wide spread of protection from losses.
But also think of it like this: A portfolio consisting only of let’s say American tech stock is the opposite of a diversified portfolio. That would be putting all your eggs into one single basket and this is extremely high risk. Because if the whole industry takes a hit, so will your stocks. So making you sure you spread across companies, as well as industries, is key!
The point of the example above is that, for example, if you only invest in companies operating in the pharmaceutical industry, you will have a higher risk than if you choose to spread your investment across companies in several different industries such as medicines, technology and consumption.
Diversifying through an index fund
If investing in multiple stocks sounds a bit stressful, a good place to start is by investing in an index fund, such as the FTSE 100 or the S&P 500. Because you’re investing in an index that mirrors the top 100 UK companies of the top 500 US companies, you get immediate access to diversification through the channel of one single fund. This helps to remove all the homework and guesswork involved in choosing individual stocks.
Diversifying asset classes
Each asset class has a different, unique set of risks and opportunities. Classes can include:
- Stocks: Shares issued by a publicly traded company
- Bonds: Government and corporate fixed-income debt instruments
- Exchange-traded funds (ETFs): A passively managed index fund which mirrors the performance of a particular market segment
- Commodities: Vital resources which are used in manufacturing processes to produce other goods
- Real estate: Land, buildings, natural resources, agriculture, livestock, and water and mineral deposits
Diversify to protect Future You from future losses.
Cyclical vs non-cyclical stocks
Stocks react differently to fluctuations in the economy, and so it is important to think about the stock’s cyclical sensitivity when choosing what to invest in. That means investing in a combination of both cyclical and non-cyclical stocks.
Cyclical stocks
Cyclical stocks is a term used for stocks that belong to a company that produces a particular good or service and where the stock price fluctuates depending on whether the economy is doing well or not. So when the economy is booming, cyclical stocks will increase. When the economy is in a recession, however, they will decrease. Examples of cyclical stocks include luxury goods, airlines and restaurants.
Non-cyclical stocks
Non-cyclical stocks is a term used for stocks that are less affected by developments in the economy (for example pharmaceutical and food). Non-cyclical stocks belong to companies which produce everyday staple products, such as toiletries, utilities, food and pharmaceuticals. Because consumers need these items everyday regardless of the business cycle, these stocks do not tend to fluctuate, meaning they stay relatively uniform in price over time.
This way, you should consider including both cyclical and non cyclical stocks in your portfolio. That way, investors gain some of the upside when the economy is booming, but you will also be protected when the economy is in a recession.
Market capitalisation (Large vs small cap)
In general, investors are encouraged to diversify and hold a mix of stocks containing both large and small companies.
Large-cap
These are big player companies that have a market capitalization of $10 billion (£7.6 billion) or more. Large-cap companies usually have consistent increases in stock price value and dividend payments
Examples of large-cap companies include: Apple, Tesla and Microsoft.
Mid-cap
Mid-cap companies generally have a market capitalisation of between $2-10 billion (£1.5 - £7.6 billion). These companies operate within an industry and are in the process of expanding rapidly. It’s their growth potential that lures people in!
Small-cap
Small-cap companies generally have a market capitalisation of $300 million - $2 billion (£230 million - £1.5 billion). Small-cap companies have lower valuations and high expectations for future growth and shouldn't be overlooked when putting together a diverse portfolio
You should try to diversify your portfolio by investing in a combination of small, mid, and large-cap companies. While it might be tempting to only invest in large-cap stocks, you need to make sure you minimise your risk when investing.
Pros and cons of diversification
Despite being a winning investment strategy within the investor world, diversification is not shy of its cons. So let’s dive into the pros and cons of diversification.
Pros
Combats risk: The main benefit of diversification is that you combat risk. By ensuring you have a mixture of different asset classes, industries and sizes, investors can relax knowing that if one market experiences a tumble, it won’t have a domino effect on the rest of their portfolio.
Exploration of different investments: This makes portfolio curation fun! Being able to delve into different types of investments will keep you more engaged and interested in different types. The good thing about investing is that nothing is ever set in stone – you can always make tweaks and changes to your portfolio.
Cons
Time consuming: Having a variety of different investments to manage and have an oversight over can be time consuming.
Expensive: Having multiple investment holdings will incur greater transaction and brokerage fees. That being said, if there is less risk attached in doing so, the rewards are balanced out.
Limits upwards potential: By protecting you on the downside, diversification limited the potential for significant upwards returns, in the short-term. Over the long term, diversified portfolios do tend to post higher returns.
Is diversification a good strategy?
Diversification is one of the strongest strategies going when it comes to investing. If risk is something that particularly concerns you, then diversification allows you to mitigate it successfully and help you preserve your capital. So with that being said, you should never enter investing without diversifying!
Final thoughts
Diversification is not to be overlooked, especially when entering the stock market for the first time. It enables you to overcome the fear factor associated with risk, and prevents you from making any emotional decisions that could ruin your potential returns. If you’re a long-term investor with a time horizon of anything above five years, then diversification will enable you stick to your long term strategy and reap the rewards of the stock market. Remember: the stock market has always increased on average 7 to 10% every year, and having a diversified portfolio will enable you to reap the rewards of that.
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