Diversification in Investing: Fundamentals, Importance & Why You Need It

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Investing is all about making money, right? You invest some of your hard-earned cash and soon the dividends begin to arrive. It seems simple enough. But how often do you look at your portfolio and see nothing but one type of investment within it? Most likely not very much. In fact, diversification is one of the most important things to learn when you are investing your money.

So what exactly is diversification? Simply put, it is when you divide your money across different types of investments.

What is Investment diversification?

Investment diversification is the practice of investing in different types of investments (stocks, bonds, mutual funds) to reduce or limit exposure to any one type of risk. Diversification aims to reduce volatility by increasing the number of investments held while simultaneously adding less overall risk.

The main point investors should take away from this idea is that if any one investment decreases in value, it will be offset by the increase in value of another. Diversification is a key element to investing as it reduces risk, especially for new investors.

Diversification does not assure a profit or protect from loss in declining markets.

How does diversification protect investors?

Investing in stocks, also known as equities, can create high, long-term rates of return. Diversification is the process of investing in more than one equity, in more than one industry and in more than one country. 

Each equity represents a partial ownership of a company. If a company were to go bankrupt, the value of the equity would possibly go to zero. By owning more than one equity, an investor reduces the bankruptcy risk faced by the  owner of a single equity. 

Additionally, diversification gives an investor a chance to make money on more than one company. When one company’s share prices decline, another company’s share prices may increase.  Diversification gives an investor a better chance at positive returns with a lower chance of losses. 

The converse is also true. An investor in a single equity may also have a better chance at significant gain than if they diversified. Any single stock may increase in value faster than a diversified portfolio. 

An investor with a large position in single equity takes on a lot more risk than they would in a diversified portfolio.  Any single stock may go to zero, but probably not a diversified portfolio. A diversified portfolio may lose money for a short period of time, but it has a much lower chance of going all the way to zero value.  In sum, the greater the risk, the greater the potential reward. A diversified portfolio spreads the risk over a number of companies, industries and areas of the world.  This is how diversification potentially protects investors.

Diversification aims to reduce volatility by increasing the number of investments held while simultaneously adding less overall risk.”

Different types of Risk

When investing, there are two principle types of risk: systematic risk and unsystematic risk. You can reduce the unsystematic risk through diversification.

Systematic Risk

This type of risk affects the market as a whole. This means that it is difficult to diversify away this risk because it is tied to the economic cycle. Stocks are exposed to systematic risks for example, interest rates or inflation may rise unexpectedly which can decrease stock prices.

Unsystematic risk

This type of risk is specific to a particular company. It can be diversified away by holding investments in many companies. For example, the invention of new technologies may increase demand for two competitors’ products so both will do well. However, if there is little or no competition, one may get large market share and reap all the profits while the other does poorly. This may sound like a risk that would only affect small businesses but Microsoft has shown that even large companies can fall prey to this.

Investing all your money in U.S. stocks is also risky because the economy of another country, such as China, could do better than our own and investors’ portfolios will be badly affected. So it is a good idea to diversify by country.

Now, which assets should you diversify into? Picking stocks, bonds and other investment assets is an area requiring years of experience & financial expertise. Luckily, we’re here to help. Speak to an advisor with A&I Financial Services to find answers.