Diversification is important in investing because you don’t want a single mistake to destroy your portfolio. Even the best investors (and businesses) make mistakes, it’s only human nature.
Diversification spreads your risk, and lowers it.
I’m sure you’ve heard the cliché that you can’t put all your eggs in one basket. This wisdom has been passed down since the beginning of civilization. You mustn’t ignore it.
With diversification, you consider and prepare for the inherent unpredictability of the market and economy, which is always present in the real world.
No matter how skilled you are, you need to be protected. The market can be very unpredictable. Every investment is a risk to be lost. The only way to ensure your success is to diversify.
Simple Historical Examples Which Showed the Importance of Diversification
Here are a few names to remember just from recent history:
- Circuit City
- Blockbuster Video
- Hollywood Video
- Washington Mutual
- Lehman Brothers
The list could go on.
These are all companies that went bankrupt, and the investors in their stocks were wiped out.
Many of these companies were very successful at one point, and even highly regarded. Enron was one of those companies that had very strong financials– a great EPS growth track record and what seemed to be a strong balance sheet.
It was only when fraud was discovered within Enron that investors found out, too late, that the emperor was wearing no clothes.
Even high-risk situations may hide in plain sight yet still be oblivious to the investing public. Some of the same companies above had huge, glaring red flags in their financials but were still bid up by investors, who all felt safe in the comfort of the crowd.
Sometimes an investment will turn out poorly because you made a mistake; sometimes the mistake will be out of your control.
That’s why diversification is so important for all investors to internalize, because you don’t appreciate it until the day it’s gone, the money is gone, and it’s too late to get it back.
What does diversification mean for your investments?
Simple Diversification Rules for Your Investments
Option 1– Index fund ETF
By far the simplest and easiest way to achieve diversification is by buying an index fund ETF, such as one that tracks the S&P 500, like $SPY.
All you have to do is buy shares of an ETF like $SPY, and receive instant diversification today and into the future.
An index ETF like $SPY works by automatically buying and holding all of the companies in the index it is required to track– in this case all of the companies in the S&P 500. The ETF holds the shares of the stocks, and by holding a share of the ETF you essentially see the same price increase as the ETF sees with its purchased shares.
Doing this is a simple yet powerful way to both participate in the growth of the economy, and achieve full diversification so that a single person’s (or company’s) mistake isn’t likely to wipe out your wealth.
Option 2– A Portfolio of 15-20 Stocks
The most common guideline for investors who pick individual stocks is usually the 15-20, or 15-25 rule.
Basically the idea, which has been backed by academic studies, is that by holding a portfolio of 15- 20 individual stocks, you will see a similar rate of volatility that the overall market does (S&P 500). This is supposed to reduce the risk of holding individual stocks substantially.
This framework works in a similar fashion to just buying an index, because it greatly reduces the risk that any one person’s (or company’s) mistake will substantially wipe out your portfolio.
However, there are still risks to this approach.
Garbage in, garbage out.
If you hold a portfolio of bad businesses, or all-expensive stocks, you might not see the same reduction of risk as someone who had a more balanced portfolio.
Also, investing in a group of stocks in the same industry will not give you the same level of diversification as investing in a group of different industries. As history has shown us many times, industries can be made obsolete by new challengers, and so a good diversification plan accounts for that risk.
Option 3– Customized Diversification
There’s an endless supply of investment vehicles which today’s investors can take advantage of to build a fully diversified portfolio.
Between the various flavors of index funds, ETFs, mutual funds, and even “robo-advising”, investors should have no problem finding a myriad of solutions to achieve these goals in a customized way.
I won’t go over every option as it would probably reach the length of a novel or more…
But here are a few additional resources we have on the blog which talk about other ways to diversify, and some of the pitfalls around the nuances of diversification:
- Why a Global Diversification Strategy is ESSENTIAL for Stock Market Investors
- How Important is Sector Diversification for the Average Investor?
- Concentrated Portfolio: The 4 Hidden Risks for the Average Investor
While these two options are common rules for diversification that many investors follow, they certainly aren’t the only ways to manage prudent diversification with your portfolio.
Even these frameworks have their inherent weaknesses; the 15-20 stocks idea is one that I’ve discussed more in-depth before.
Great diversification can sometimes be subjective, but in general you can’t go wrong with more “eggs in the basket”.
Remember that there are tradeoffs…
Usually more reward goes to those who take greater risk, often in the form of less diversification.
But we can remember to be weary of chasing that kind of return, as it’s very unsustainable. The “15 minutes of fame” is really a common thing in the stock market, as countless high performing fund managers have come and gone, as they shot to the moon and then imploded.
For average investors, we must have the humility to understand that the market is complex, the future is uncertain, and we don’t have all the answers.
So what’s the answer to all of that?