What’s Diversification and Why Is It Important?

Whether you’re investing to build wealth or beef up your nest egg to retire comfortably, it’s important to understand why diversification is significant. But if you aren’t quite familiar with the term or have heard of it but don’t know what it means, it’s important you get caught up to speed. That way, you’ll understand the best strategies to derive the greatest return on your money.

Diversification, Explained

In a nutshell, diversification is a strategy employed by portfolio managers to minimize the risk of loss on investments. So instead of pooling all your funds in a single investment in the same industry, they disburse your investment across industries into different types of financial instruments with the goal of maximizing your earnings. 

Types of Risk

There are two types of risks you should be mindful of with regards to investments:

  • Diversifiable- commonly referred to as unsystematic risk and is directly linked to industry, entity, specific market, or country. As an investor, you can control diversifiable risk by allocating your investment across various industries, asset classes, and companies. Doing so minimizes the risk of loss caused by poor market performance. 
  • Undiversifiable- also known as market or systematic risk that is inherent and cannot be eradicated through diversification. In most instances, undiversifiable risk is caused by market factors that are out of the investor’s control, including but not limited to market events, interest rates, exchange rates, and volatility in politics. 

Why Is Diversification So Important? 

For years, it has been argued by financial professionals that diversification and asset allocation are the most fundamental factors of building wealth and. Why so? 

Diversification ensures that you don’t put all your eggs in one basket, which minimizes risk. Otherwise, you could take a big hit if a particular company or industry started showing signs of declining performance, or even worse, tanked overnight.

Asset allocation is simply a form of diversification that allows you to spread your investment out amongst asset classes or investment instruments, which include stocks, bonds, real estate, cash, gold, and commodities, just to name a few. And if one asset class starts to decline in value, you won’t take a huge since the others could help absorb some of the losses.

Scenario #1: The housing market tanks, causing an uproar on Wall Street and chaos in the U.S. financial markets.

You can expect every mortgage company and financial institution to experience declines in performance. This means you could incur substantial losses, unless you have funds invested in safe assets, like government-backed bonds. 

Scenario #2: A war breaks out in Russia where a bulk of your investments are held, and the economy takes a major hit. 

Regardless of the types of holdings you have, your Russian portfolio will more than likely plummet. But if you have investments in the US, you may sustain fewer losses. 

Scenario #3: Mechanics employed by an automotive company you hold shares in go on strike. 

Strikes are common and a sign of brewing financial troubles for investors. If you don’t have shares or other assets in other automotive companies or industries, expect to take a big hit. Also, keep in mind that equity and bond markets tend to move in different directions, so you can minimize your risk by having a healthy combination of both.

How to Diversify Your Investments

Step 1: Select asset categories with a history of strong performance.

Historically, some asset classes have performed much better than others. To illustrate, bonds are almost a safe bet while stocks and commodities tend to be a bit more volatile. Consequently, investors who are willing to take on moderate risk or who are risk-averse are more inclined to invest in bond funds and hold them in their portfolio for an extended period of time. And they’ve more than likely yielded the returns they were looking for.

An important note: the asset categories you select will depend on how much risk you’re willing to take. If you’re young or have a ton of money to play with it and want to go all in to see how much you can make in the shortest period of time, you may find stocks in high-growth industries, like tech, more appealing than bond funds. But with the potential for great returns comes the risk of loss. 

So before you make a decision, consult with a financial advisor for additional guidance. They will help you devise a plan and determine how much risk you possibly absorb take on without putting your financial wellbeing on the line. 

Step 2: Conduct your research to find industries that you’re most interested in.  

If you find a particular industry or company intriguing, you’ll be more inclined to follow their performance over time. And doing so is pertinent to being a responsible investor as you want to be on the lookout for key performance indicators, like dividend yields and earnings per share (EPS), could be a sign to up your investments. But if the company or overall industry starts to go downhill, that could be your sign to adjust your asset allocation strategy or move on. 

You should also confirm that companies in this industry have a track record of yielding generous returns for investors.

Some Important Considerations 

While diversification is an ideal way to protect your hard-earned money when investing, it’s not without fault. A few important considerations when devising an investment strategy:

  • Undiversifiable risk is out of your control, as mentioned earlier. So no matter how hard you try to cut your losses, it’s nearly impossible in some circumstances. 
  • The costs to diversify can add up quickly, which in turn impacts your bottom line. 

What does this mean for investors? You can pay the cost to minimize risk by investing across the board in different asset classes across industries. The systematic risk will be there, but you’ll be doing your part to protect yourself as much as possible. However, This equates to more brokerage charges and transaction fees if the need arises to buy or sell.

The other option: keep it simple by not diversifying much, which saves money. But if you take this approach, you run the risk of breaking even or losing in the end. 

Or you can merge the two approaches to derive the most affordable, but effective benefit. 

The Bottom Line 

It’s really that simple, and with the help of a reputable financial adviser, you can invest with confidence knowing that your funds are invested across industries in top-performing financial instruments. Even better, diversification will help you minimize risk so you won’t have to sit on the edge of your seat in worry each time the financial markets start acting strange. You’ll be able to call up your financial adviser, make some minor adjustments, and get back to life.