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.
Why is Diversification Important in Investing?
Diversification is important in investing because the market can be unpredictable. Diversification means to spread your money between different investments to reduce risk. The goal of diversification is to improve your investment returns and ultimately grow your money faster.
Diversifying is like saying I don't know which horse is going to win so I'm going to bet on all of them!
As legendary investor Sir John Templeton once said: “Diversify. In stocks and bonds, as in much else, there is safety in numbers”.
By diversifying your portfolio, you are reducing the consequences of making a poor investment decision.
What Is Diversification?
Basically, diversification is when you hold investments that react differently to the market at any given time.
For example, stocks tend to outperform bonds during a bull market (when the market is growing). While bonds tend to outperform stocks during a bear market (when the market is declining).
By holding a diversified portfolio of stocks and bonds you are effectively minimizing risk at any point within the market cycle.
The common analogy people like to use to explain diversification is “don't put all your eggs in one basket, because someone might take your basket!”
Some people believe you must spread your money evenly between many asset classes to be diversified, but this isn't entirely true. As I'll explain further below.
Diversification is important in investing because… Well, let's explore the benefits of owning a diversified portfolio!
The Benefits of Diversification
Here are some of the benefits of owning a diversified portfolio.
It's an Easy Way to Guarantee Average Returns
Diversifying your investment portfolio (through index investing) is one of the easiest ways to guarantee average returns in the stock market.
This is why index funds are becoming so popular.
When you are buying an S&P 500 index fund, for example, you are buying a portion of all the stocks that make up that index. Meaning you're buying 500 separate stocks that belong to different sectors within the market.
Your portfolio value may go up or down in the short-term—but you're almost guaranteed to build wealth over the long-term!
Less Portfolio Volatility
The point of diversifying your investments is to reduce the impact that market fluctuations will have on your portfolio.
And U.S stock market indexes will always pay a healthy dividend of 3-5%—no matter what the rest of the market is doing!
So you will always receive income while owning an index fund—no matter what phase of the market cycle!
The Disadvantages of Diversification
Here are some of the disadvantages of owning a diversified portfolio.
You Could Miss Out on a Hot Stock
You are potentially missing out on high returns in individual stocks by owning a diversified portfolio.
You might only dedicate 5% of your portfolio to Apple's stock and sure enough, it's stock price doubles in a matter of months.
You would have made a much greater return if your entire portfolio was made up of Apple stock!
Although, there are arguments to be made against this investing style (focus investing) as well. But, I won't get into that here.
Sometimes people get lucky during a bull market. They pick a winner from a tip, think they're a genius—and try to do it again. Or as Charlie Munger would say: “Bull markets go to people's heads. If you're a duck on a pond, and it's rising due to a downpour, you start going up in the world. But you think it's you, not the pond.”
Owning a managed index fund will prevent you from getting excited during bull markets and overpaying for stocks!
How to Diversify a Portfolio
Many people believe that a diversified portfolio should be made up of the following asset classes:
- Real estate properties
- Foreign currencies
- High-interest savings accounts (Like CIT Bank)
- Certificate of Deposits (CDs)
However, you don't need to diversify this aggressively when you have a long-term outlook.
Your investment portfolio should be made up of 15-20 stocks to be considered diversified.
How to Diversify a Bond Portfolio
You'll want to invest your money equally between three of the asset that I have just mentioned.
It's also good to have some money either stored in a high-interest savings account or invested in bonds at all times. This way, you'll know that you always have some cash on hand.
The safest bonds to buy are US Treasury (savings bonds), they are backed by the United States government and it is highly unlikely that you won't get your money back.
When to Rebalance Your Portfolio
A common rule among investors is to never let stocks take up more than 75% or less than 25% of your portfolio—with bonds or savings accounts making up the other portion.
This allows you to sell bonds and buy stocks when the market is cheap, and sell stocks to buy bonds when the market is expensive.
How to Tell If You're Diversified
The easy way to tell if you're diversified is to look at your portfolio's performance over the past twelve 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 time your portfolio might be too focused. If so, you might want to reevaluate your portfolio to ensure you are properly diversified.
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.
It's important to remember that there will always be a level of risk involved with investing—no matter how diversified you are.
If you'd like to learn more about investing in stocks visit here: How to Invest In Stocks For Beginners