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Diversification: What it Is & How it Works

Luisa Rollenhagen

Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.

Imagine you’re walking down the street, minding your own business, when all of a sudden you walk past a candy shop, the kind where you can scoop the candy out of bins and fill up a plastic bag full of sugary treats and then pay by weight. The neon glow of the gummies and candies are a visual siren song, and the indomitable need for sugar suddenly overwhelms you.

You could fill the bag with just jelly beans, but what if they have deceptive flavors like licorice or, God forbid, banana? The Coke-bottle-shaped gummies look appealing, but what if they’re too waxy? What if the chocolate bites are too chalky? Sampling the wares before purchasing is pretty frowned upon, so you do the following: You fill your bag up with safe bets, like gummy worms and sour bears, and then throw in some wild cards, like the weirdly shaped marshmallow bits or the strange purple jelly beans. That way, if one pick ends up being a miss, you’ll still have plenty of other candies in your bag to shuttle you towards your next cavity. And just like that, you’ve practiced diversification.

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Diversification is a strategy meant to reduce risk by ensuring that you don’t put all of your money on purple jelly beans, and instead end up with a candy bag full of different options. If you’re lucky, they’re all delicious. If you’re less lucky, then the duds will be kept at a minimum because you’ve made sure to include plenty of other candies in your bag as well. In investing terms, this means that you’ll want to ensure that your portfolio isn’t overwhelmingly reliant on one particular industry or—even worse—one company in particular.

That way, if, say, cryptocurrency ends up being more of a bust than a boom, you’ll probably be relieved that only 4% of your portfolio was invested in that area, and that your investments are bolstered by the presence of blue chip companies and investments in areas as diverse as real estate, bonds, and energy. If, however, 60% of your portfolio is invested in cryptocurrency, then a bust won’t just sting—it can mean serious financial losses. Furthermore, the rationale is that in the long term, a diversified portfolio consisting of various different assets can yield more consistent growth than individual assets alone. So diversification can definitely be an appealing investment strategy for all investors to keep in mind, from the bloody beginner all the way to the next coming of Warren Buffett. And if you’ve spent any time with us, you’ll probably know by now that we’re pretty partial to it as well.

In fact, this idea is so popular that a guy named Harry Mankowitz even won a Nobel Prize in the 1950s for coming up with a theory that has the ethos of diversification at its core: Modern Portfolio Theory. The basic idea behind this theory is that diversification is an efficient and risk-mitigating strategy for managing long-term financial goals, like a retirement fund (which you wouldn’t want to expose to too much risk in the first place). This is done by finding a combination of assets spread across a wide field of sectors in order to prevent wild swings in value and provide decent returns.

Featured snippet: Define Diversification A: Diversification is a strategy that aims to mitigate risk and increase chances of long-term growth by investing in a wide variety of assets and sectors instead of focusing heavily on one area or company.

The importance of portfolio diversification

Diversification has a solid fan base. Portfolio managers, financial advisors, and even a Nobel Prize winner tout its benefits. But what exactly are those, and what can diversification do for the average investor? We’ve got a rundown of diversification’s benefits, but always remember: Investing is always inherently risky, and past performance is no guarantee of future results. Just because something worked in the past doesn’t mean it’ll necessarily work just like that in the future. That being said, here are some reasons why a diverse portfolio is a popular investing strategy:

  • Managing risk. The most prominent benefit of diversification is that a diversified portfolio can be really helpful in ensuring that you’re minimizing your risk as much as possible. A portfolio consisting only of one stock or investing only in one sector is screwed if that particular company or that sector of the economy experiences a downturn. But it’s way more unlikely that, say, 25 companies go down at the same time. So the risk of major losses is reduced in a diversified portfolio.

  • Preserving capital. While diversification usually won’t lead to any catapulting short-term growth, it tends to be a popular method of preserving the capital you already have while benefiting from steady, long-term growth. Because of the low risks associated with a diversified portfolio, investors who want to preserve their capital for long-term goals like retirement are often more likely to benefit from diversification.

  • Access to different assets. The great thing about diversification is that it’s basically made for indecisive people. Want to dip into the new world of cannabis stocks? Are you passionate about renewable energies? Keen to get some blue-chip stock into your portfolio? Diversification allows you to try many types of investments at the same time.

  • Possibility of higher long-term returns. As mentioned before, there are no guarantees when it comes to investing. But a diversified portfolio, which includes a wide variety of assets and sectors, can help raise the odds that you’ll be in on the fun when certain companies or industries start taking off and generating high returns. And even if that doesn’t happen, a well-diversified portfolio that, at least in part, tracks a specific index market like the S&P 500 will usually experience a steady growth that mirrors the ongoing growth of the market.

Limitations of diversification

  • Limited short-term gains. Because diversification consists of not betting everything (or a significant amount) on a specific company or industry, it means that you might miss out on significant short-term gains if your bet turns out to be fortuitous. Let’s say you invested $100,000 equally across ten stocks, and one of those stocks has a sudden increase in value, almost doubling its price. That means you’d now have a $20,000 stake in that stock, but if you had invested the entire $100,000 in that stock, you’d have a value of $200,000. But also remember that the risk of incurring significant losses also increases when you invest in this way.

  • Can be difficult to manage. If you’re taking an ad hoc approach to investing, you’re going to have to spend a lot of time researching and rebalancing your portfolio if you want to keep it diversified. You’ll have to keep track of more investments, and research more companies and industries to decide where you want to place your money. Of course, this stress can be avoided if you’re investing with a robo-advisor, where an algorithm automatically designs and manages a diversified portfolio for you, calibrated to your financial goals and desired level of risk.

  • Potential higher fees. Whether you’re managing your portfolio yourself or paying a financial advisor or portfolio manager to do it, the truth is that more assets usually means more fees. You’ll likely be paying commission and transaction fees for more assets, especially if you need to trade more often to maintain a balanced portfolio. Costs can be significantly reduced with the use of a robo-advisor, which usually doesn’t charge commission fees and has lower maintenance costs.

  • Increased risk without a strategy. If you’re just blindly investing in everything just for the sake of diversifying, you could actually increase risk. If you’re investing in inherently risky assets like hedge funds, gold mines, or emerging markets without understanding their risk or how much of your portfolio, if at all, you should allocate to these assets, you could potentially incur higher losses.

How does a diversification strategy work

Despite some disadvantages, many investors continue to choose to engage in at least some level of diversification when investing. If you want to employ a diversification strategy in your own investing, there are a couple of things you’ll need to follow.

Ensure you have a good mix of assets

For people looking to build a diversified portfolio, an initial starting team of about 10 to 20 different assets—including individual stocks, index funds, bonds, real estate, mutual funds, ETFs, and even cash—is usually considered a solid set-up. Within your stocks, you can also try to have a mix of blue-chip, mid-cap, and small-cap stocks to diversify even further. The level of diversification is up to you, and you can also choose to diversify further by ensuring you’re spread out across several industries such as renewable energies, health, and agriculture.

As mentioned before, it’s important to understand the sectors you’re investing in, and calculate how much money you want to invest in them in relation to their risk level. ETFs tend to be a popular way to automatically build in diversification while reducing risk and costs. Because ETFs let you buy a wide variety of stocks and assets in one bundle, you get wide market exposure, especially if they’re index-based (meaning the assets in the ETF are listed on market indexes like the S&P 500). Plus, ETFs have significantly lower costs, so you get to participate in a wide swath of a market at a fraction of the price.

Consider geographic diversity as well

Another way to practice diversification is to invest in a mix of domestic and international markets. Stocks from international markets may perform differently than those in a domestic market, so it can be a good way to balance out any dips in performance that your domestic assets might experience. On the flip side, investing internationally can lead to gains as emerging markets, or access to industries that may not be as developed domestically.

Diversify your risk level

Having a wide variety of assets is a great start, but it’s not a bad idea to diversify the level of risk within those assets. For example: Depending on your risk tolerance, you could split up your money among assets with pretty low volatility, potentially low returns (such as blue-chip stock), medium volatility, potentially medium returns (such as a mix of mid-cap and small-cap stock), and high volatility, potentially high returns (such as cryptocurrency). Obviously, the more risk-averse you are and the more you’re investing for long-term goals such as retirement, you’ll want to ensure you keep high-risk investments to a minimum.

Rebalance your portfolio as needed

Once you have your dream team of assets lined up for your portfolio, a passive investment strategy dictates that you basically set it and forget it, allowing your portfolio to grow alongside the market with the help of regularly scheduled deposits into your investment account. However, things change, the market shifts, and stocks don’t ever stay static. That means that you’ll occasionally have to fine-tune your portfolio to make sure you’re still maintaining the same risk-to-returns ratio and asset distribution you initially set up.

It’s also possible that your financial goals change over time, and you’re suddenly in a position where you have more disposable income, meaning that you’re willing to take on a bit more risk to potentially grow your money more extensively. In either case, that means you or your portfolio manager will have to sell or buy assets accordingly to maintain a desired balance. This can get pretty expensive and requires loads of research, which is another reason why a robo-advisor may come in handy here: Many of them offer automatic portfolio rebalancing at no extra fee.

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Last Updated July 31, 2019

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