Diversification

Broaden Your Horizons

What is diversification?

Diversification is a way to minimize risk by spreading out your total investment across different assets, such as stocks, bonds, ETFs, and real estate.

The purpose of diversification is to limit the probability that all your investments will lose value at once. If one investment loses value, your other investments should remain unaffected, keeping your overall losses to a minimum.

Diversification can also be achieved by investing in specific securities in different sectors or industries, or by investing in securities issued by both domestic and foreign entities.

Sample investment portfolios

Aggressive diversified portfolio

  • Stocks 40%
  • Bonds (maybe including junk bonds for the high-risk tolerant) 20%
  • Active ETFs (return oriented, actively managed, not index based) 30%
  • Cash or money market funds 10%


Conservative diversified portfolio

  • Stocks 15%
  • High-rated Bonds 40%
  • Mutual funds 30%
  • Cash or money market funds 15%

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Protect your eggs!

Don’t put all your eggs into one basket, as the saying goes.

Diversification means purchasing a wide variety of asset classes, such as investing in the stock market and owning rental real estate, so that the likelihood of losing money on all your investments at once is diminished.

By putting your money into many different asset classes, or baskets, you spread out your risk. A downturn in the stock market or a bad investment pick may cause one of your eggs to tumble and fall, but the others should still be safely tucked away elsewhere.

How it works

Consider the two investment portfolios below. One is diversified into a number of asset classes, while the other contains only a single stock. Notice how the same negative market event has a very different impact on the two portfolios.

Double down on diversification

You can diversify your investments in many different ways. The above example describes midlevel diversification—investing in different asset classes to spread out risk—but you can further diversify by investing in foreign assets or by diversifying the specific securities you purchase within a single asset class.

For example, if you choose to invest part of your portfolio in bonds, you can achieve some level of diversification by purchasing bonds from different issuers. Instead of buying only bonds issued by Company A, you can buy bonds from Companies A–E as well as those issued by the U.S. government or other highly stable nations.

If something happens to Company A and it defaults on its bond debt, your other bonds should still perform as expected. If the American economy takes another dive and several of your domestic bonds lose value, your foreign investments should provide some security.

By investing in a wide range of assets and then further diversifying by purchasing different securities within each asset class, you can diversify and protect your portfolio on several levels.

Things to remember

  • Diversification is a way to limit your overall risk by spreading out your investments.
  • You can diversify in two key ways:
    1. By investing in several different asset classes, such as stocks, bonds, or real estate.
    2. By investing in different securities within the same asset class, such as several different stocks in different industries or bonds issued by both foreign and domestic entities.
  • While diversification is important, you should still choose assets and specific securities that match your overall investment goals and current financial situation.
  • For example, diversifying into bonds is not a good choice if the only bonds you can afford are low-rated junk bonds, which trade at huge discounts due to the high level of inherent risk. Investing based on what asset is cheapest is rarely a good idea, so make sure your diversification choices are still prudent investments.

Fun facts:

  • The concept of diversification as an investment strategy was first officially defined in 1952 by American economist Harry Max Markowitz as part of his Modern Portfolio Theory.
  • The word diversification comes from the Latin words diversus, meaning “turned in different ways,” and faciō, meaning “make do.” Diversification is simply the act of making something turn, or face, in different directions.

 

References

  1. https://www.sec.gov/investor/pubs/assetallocation.htm
  2. http://www.investopedia.com/terms/d/diversification.asp
  3. http://www.investopedia.com/articles/02/111502.asp
  4. http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2013/05/31/heres-why-diversification-matters
  5. http://www.investopedia.com/articles/basics/05/diversification.asp
  6. http://finance.zacks.com/portfolio-diversification-theory-6684.html
  7. https://en.wikipedia.org/wiki/Harry_Markowitz
  8. https://en.wiktionary.org/wiki/diversification

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