What is Diversification?
Diversification is important for optimal investing. But what does this term mean, and how can you build a diversification strategy that works for you?
February 21, 2022
“Don’t put all your eggs in one basket.”
We’ve all heard this saying, but what does it really mean?
Essentially, these wise words mean that you don’t want to keep all your precious eggs in the same basket – because if something happens to that basket – you could lose all your eggs.
On the other hand, if you had 10% of your eggs each in 10 different baskets, your eggs would be far more protected from accidents.
This is the basic principle of diversification — you don’t want to risk everything, so you’re better off spreading out your bets.
This same principle applies to our finances and specifically to our investment strategies.
This guide will cover the basics of diversification and introduce the basics of a diversification strategy that you might want to use.
What is diversification?
In the financial world, diversification refers to investing in a wide variety of assets in order to “spread out your bets,” so to speak.
The idea is to limit your exposure to any one particular asset, so that if that asset doesn’t perform well, your entire portfolio won’t be greatly affected.
For example, a diversified investment portfolio may include index funds with thousands of stocks, plus bonds, real estate and perhaps even some alternative assets like precious metals or cryptocurrency.
That way, if the stock market starts to crash, the bonds, real estate and alternative assets may help to reduce the effect on the portfolio. The basic principle is that diversification helps smooth out the bumpy ride of investing, as each asset class tends to increase or decrease in price independently from one another.
Diversified is the opposite of concentrated
The idea is to not have your investments overly concentrated on any one company, industry or asset class.
To help illustrate, let’s look at the opposite of a diversified portfolio.
Let’s say you invest all your money in the stock of a company that you like. It does well for a few years, but then a recession hits, and the company is forced to declare bankruptcy.
In this case, you could lose your entire investment.
But if you had held a diversified portfolio instead, the crash in this one company’s stock likely wouldn’t have had such a large impact on your overall portfolio. For instance, if you had invested 1% of your portfolio, the bankruptcy of this one company wouldn’t affect the other 99% of your investments.
Diversification strategies for investing
Note: This is for informational purposes and should not be taken as investment advice. It’s recommended to speak with a qualified financial advisor for help developing your own investment plan.
When it comes to investing, diversification is mostly about managing the level of risk associated with your investments.
If you invest only in stocks, the long-term returns are likely to be good. However, the risk is also higher, particularly over shorter periods of time.
Thus, most investment professionals encourage clients to diversify their investments into different asset classes. This guide from the Securities and Exchange Commission (SEC) does a good job of explaining the different asset classes and how to diversify your investments.
A diversified investment portfolio may include some or all of the following:
Stock market index funds, which invest in hundreds or thousands of individual stocks
Bond index funds, which invest in hundreds or thousands of individual bonds
Real estate, or real estate investment trusts (REITs) which buy many different properties
Cash or cash-equivalents
One simple way you might improve the diversification of your investments is to utilize index funds. Index funds are an investment product that invest in hundreds of different stocks. You buy into the index fund and then own a small share of each stock that’s included in the index.
For example, S&P 500 index funds invest in the 500 largest publicly traded companies in the USA. Instead of buying shares in all 500 of these companies, you can simply invest in an S&P 500 index fund.
Advanced diversification strategy
More advanced investors may also wish to further diversify their investments. Some examples of strategies they may wish to utilize include:
Investing in international stocks as well as domestic stocks
Investing in specific industries
Buying individual bonds and individual stocks instead of just index funds
Buying alternative assets like cryptocurrency or gold
Buying different types of stocks, like small company stocks, or less volatile defensive stocks
Investing in commodities or futures contracts for commodities
These are just some ideas — experienced investors will want to spend time consulting professionals and doing their own research to construct the optimal diversification strategy for their goals and risk tolerance.
Diversification is not just for investing
While much of the focus of diversification strategy focuses on how to diversify your investment portfolio, the reality is that we can all benefit from diversification in the rest of our lives.
It’s beneficial to learn about a wide variety of topics to sharpen your mind.
It’s best to surround yourself with a diverse group of friends and coworkers to expand your social circle and be exposed to new ideas.
It’s best for businesses to sell several products in case one doesn’t sell well or there are supply-chain issues for a product.
It’s best to have a diverse set of hobbies and activities to keep things interesting.
These are just a few ideas on how you can apply the principles of diversification to your own life (and your investments).
Diversification is vital for long-term investing success.
Finally, if you have high-interest credit card debt, keep in mind that it may make more financial sense to pay off this debt first. Investing is vital, but if you’re paying 15 to 25% or more in interest, paying this off first should be a priority.
And if paying off credit card debt is on your to-do list, Tally† may be able to help. Tally is an app that helps qualifying applicants consolidate their credit card debt at a lower interest rate to pay it off faster.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. Based on your credit history, the APR (which is the same as your interest rate) will be between 7.90% - 29.99% per year. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.