Let’s talk about diversification.
It’s something that even veteran investors need to keep in mind if they hope to see their portfolios through the highs and lows of the market over time.
What is diversification?
Diversification means purchasing multiple investments (instead of just one), so your portfolio’s performance is not tied to a single asset class, industry, company, or geographical region.
A well-diversified portfolio has exposure to a variety of different industries, companies, geographical areas, and asset classes, like stocks, bonds, commodities etc.
Though a diversified portfolio is by no means risk-free, spreading your money around into different investments can help blunt your losses when the markets take a negative turn.
Investors diversify their portfolios to reduce risk.
Let’s try to visualize it.
In practice: Non-diversified versus diversified portfolios
Below we’ve charted the performance of a fictional portfolio–we’ll call it Brandon’s portfolio–over the course of 12 months.
The portfolio has just one holding: Shares in a fictional company called BK Tech Inc.
As you can see, the stock’s performance–and thus the entire portfolio’s performance– have had gains and losses over the course of a year:
After a year, given the peaks and valleys, Brandon’s portfolio’s performance ends up where it began. That is, it had a return of 0%, as its one holding (BK Tech stock) ended the year right where it started, at $20 per share.
Now, take a look at a diversified portfolio, which we’ll call Ed’s portfolio. This portfolio, rather than having one holding, has five: BK Tech stock, as well as other shares of fictional companies and ETF funds, which themselves are baskets of securities and bonds.
While some of the holdings of the diversified fund have performed poorly, others have done well. The key, however, is to look at the average of all the holdings to get a sense of how the portfolio has performed as a whole:
By tracking the yellow line in the graph (the average), you can see that Ed’s diversified portfolio has delivered a positive return for the year.
Now, we can compare the two to see how they performed:
In this example, Ed’s diversified portfolio outperformed Brandon’s portfolio. Not only did it outperform, though, it also performed in a smoother, less volatile fashion. The price swings were less dramatic.
This does not, however, mean that a diversified portfolio will always outperform a non-diversified one; This is just an example using fictional data, and as always there is risk involved with investing.
Diversification and risk
Brandon’s portfolio is subject to a higher level of risk than the diversified one. That’s because Brandon’s portfolio, as you’ll remember, contains only one holding: BK Tech stock. If the stock market were to drop, or the tech industry was to experience some sort of unforeseen new hurdle (a shortage of production inputs, new regulations, etc.), Brandon’s portfolio would bear the brunt.
A diversified portfolio would still be affected, as it contains BK Tech stock as well, but it would be buoyed by its other holdings, which includes the stock of numerous companies, not to mention bonds.
So, in our example, the diversified portfolio outperforms Brandon’s at the end of the year due to its wide array of holdings. Again, though, it’s important to keep in mind that a diversified portfolio doesn’t necessarily lead to stronger performance.