The term diversification is a term regularly associated with investment strategies and it is without a doubt the single most powerful tool available to investors. Diversification isn’t a difficult concept to understand, yet it is still often misunderstood.
So what is diversification?
You can find various definitions of what exactly diversification is, but put simply:
Diversification is the strategy of spreading your money out over multiple investments rather than putting all your eggs in one basket.
Rather than holding just a few stocks and hoping you (or your portfolio manager) has managed to pick the next star, you invest in many different companies or asset classes.
The strategy is designed to reduce the risk in a portfolio by combining investments that are unlikely to move in the same direction at the same time. This is based on the proven fact that not all asset classes, industries and stocks behave the same under similar conditions.
An example of this is when equity markets experience a sharp fall in prices we often see bonds increase in value moving in the opposite direction. The risk to the investor is if they were only exposed to equities their entire portfolio would lose value. Investors exposed to both equities and bonds would have some protection built into their portfolio from downside events. Diversification reduces the downside risk and allows for more consistent performance under all economic conditions.
Using the strategy of diversification can help investors accomplish the following:
- Decrease your risk. That is to say, you have less risk of losing your investment when you diversify it.
- Diversification can reduce your risk without decreasing your expected return. You can expect your investments to perform as uncorrelated assets.
Why is diversification so effective?
Below are a few key reasons why diversification is such an effective tool:All stocks represent a lot of risk as well as potential reward. The fact is any company at any time has the potential to fail for many reasons. Holding only a few stocks increases your risk significantly.
- All stocks represent a lot of risk as well as potential reward. The fact is any company at any time has the potential to fail for many reasons. Holding only a few stocks increases your risk significantly.
- Conversely, over the long-term the stock market as a whole has proven to be a solid investment. Individual companies may liquidate or lose their competitive edge, but business in general continues.
- Most investment professionals in the banking industry are very poor at picking stocks despite the unjust high fees they charge. As an example; 86% of active fund managers failed to beat the benchmark chosen by themselves in 2014.
By diversifying and not putting all your eggs in one basket investors reduce their risk while still being exposed to the growth of the broad market as a whole.
Same expected return, less risk of losing your invested capital.
So what’s the catch?
The main argument against diversification is that you are unlikely to strike it rich overnight.
Since your portfolio is spread across a greater number of companies and / or asset classes you are not concentrated in any one area. While it is true that if you had put all of your money into Apple (AAPL) or Google (GOOG) before their share price jumped you would likely be wealthier today the chances of spotting these future stars are slim even for the most seasoned investor. In fact the evidence strongly states very few professional active managers consistently get it right.
Even highly successful investors are strong supporters of diversification. To quote Warren Buffet:
“If you are not a professional investor… then I believe in extreme diversification. So I believe 98% or 99%, maybe more than 99%, of people who invest should extensively diversify.”
Research shows individual investors consistently get lower returns than the market as a whole as they are prone to chasing the next star stock. Likewise investors tend to chase returns of an active manager based on recent short-term performance rather than evidence of long term outperformance of a benchmark.
To sum up, while it is totally possible for an investor or professional manager to pick the next rising star it is much more likely that this will strike out. To put it another way, the downside risk is far greater, and much more likely, than the upside potential.
Diversifying may not be sexy, it definitely won’t make you rich quick, but it’s the strategy that has proven to most likely succeed in growing your money over the long term with a lot less bumps in the road.
This article was originally posted on the Cocoa Invest blog.