Why Diversification Is Important in Investing

A lot of people wonder, do they need to diversify their money and is diversification important in investing?

I'm going to explain why diversification is important in investing, how to tell if you're diversified, and how to diversify your portfolio.

Understanding Sources of Risk

Before you start diversifying your portfolio, you need to understand the sources of risk that can affect your portfolio. The type of risk that affects every company within a market is called systematic risk. 

Examples of systematic risk include interest rates, corporate earnings, government policy, currency value changes, natural disasters, and economic recessions. I'm going to explore the most important sources of systematic risk below.

Interest Rates

Changes in interest rates will affect your portfolio in different ways. Businesses and consumers will cut back on spending as interest rates rise, causing earnings to fall and stock prices to drop. On the other hand, when interest rates have fallen significantly, consumers and businesses will increase spending, causing stock prices to rise.

Corporate Earnings

Corporate earnings can also impact stock prices dramatically. Stock prices tend to rise when earnings results exceed market expectations, while disappointing earnings results tend to lower share prices. Corporate earnings are typically released either quarterly or semi-annually, so you can expect stock prices to rise and fall significantly during these periods.

Government Policy

Government policy changes can create an uncertain environment for investors. Governments can do many things to affect stock prices like creating subsidies, taxing the public and giving the money to an industry, or tariffs, adding taxes to foreign products to lift prices and make domestic products more appealing.

Natural Disasters

Natural disasters affect the US economy more than many people realize. The largest disasters slow regional economic growth for decades. Bridges, roads, and utilities are destroyed. Homeowners who aren't covered by insurance go bankrupt. Many can't rebuild and must move elsewhere. The 2017 natural disaster season cost the US economy $306 billion alone.

Mitigating These Risks with Diversification

Diversification is important in investing because it can mitigate risks that cause economic uncertainty. A properly diversified portfolio can enjoy higher returns and reduced volatility.

Here are some great diversification strategies that can reduce your portfolio's volatility and increase your overall returns.

Own Assets in Different Industries

Let's pretend that you only owned airline stocks and the pilots announced that they were going on an indefinite strike. The stock price would likely fall and your portfolio would experience a sharp drop in value. Your portfolio, however, would be less affected if it was made up of 50% airline stocks and 50% consumer staples stocks during this period. You can see how diversifying among many industries can increase your returns by giving you exposure to more companies while decreasing portfolio volatility.

Invest Abroad

Another way to diversify is to invest abroad. While US stock markets represent just over 50% of global stock markets by market cap, there are many opportunities for growth overseas. You will also be less affected by domestic government policy changes when you own foreign stocks.

Invest in Stock and Bond Index Funds

Stock and bond index funds are a great way to easily own assets across different industries and even abroad. A popular bond fund that owns bonds from the entire market is Vanguard's Total Bond Market Index Fund. Bonds don't perform nearly as well as stocks over the long-term, but they are another way to diversify your portfolio.

S&P 500 index funds are great because they buy part of 500 of the largest US stocks among various industries. They don't however, own many mid and small-cap stocks, meaning you will be missing out on gains from startups and other mid-sized companies.

Vary Company Size

The easiest way to invest in US companies of various sizes would be through a total market index fund like Vanguard's Total Stock Market Index Fund which owns roughly 3,500 stocks. Both of these stock market index funds are great performers, but Vanguard's S&P 500 index fund has outperformed their Total Market Fund by about 0.50% over the last 10 years, so I'd have to recommend that fund.

How to Tell If You're Diversified

Most experts recommend that your portfolio should be made up of 15-20 stocks.

The easy way to tell if you're diversified is to look at your portfolio's performance over the past 12 months. Stocks in a diversified portfolio will typically rise and fall at different times. If some of your stocks are up while others are down—you're diversified.

However, if your stocks seem to rise and fall at the same time, your portfolio might be too focused. If so, you might want to reevaluate your portfolio to ensure you are properly diversified. 

Do I Need to Diversify?

Diversification is the best way to invest for 99% of people. Hedge funds and other investing professionals may have greater investment success by opting for a focused portfolio which could mean owning as little as 5-8 stocks.

In fact, Coca-Cola made up over 20% of Berkshire Hathaway's portfolio at its peak. Warren Buffett (through Berkshire Hathaway) initially bought $1.8 billion in Coca-Cola stock, which is worth about $22 billion at the time of writing.

So you can see that some people can be vastly successful without diversifying, but most people don't have the time or the skill to be successful without owning a diversified portfolio.

Summary on Why Diversification Is Important in Investing

Many people diversify for their portfolios because it's an easy way to guarantee average returns while experiencing minimal portfolio volatility.

However, it's important to know that you can never fully eliminate the risk associated with investing in the stock market—no matter how diversified you are, but you can reduce the risk associated with individual stocks.

For example, even self-made billionaire investor Warren Buffett has lost money on individual stocks (he lost $5 billion or 34% of his investment in 2019 on Kraft Heinz).

Fortunately, his stock portfolio was comprised of over 10 other stocks, making this loss a lot less painful.

The best way to mitigate general market risks is to invest in companies in different industries, in different countries, and even among different asset classes.

If you'd like to learn more about investing, visit my how to invest $1000 article where I explore the best ways to invest your first $1000.