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Finance 101: What does ‘diversification’ mean?

If you’ve every heard anyone talk about investing, you have probably heard someone mention the need for a diversified portfolio. So, what does that mean? Is diversification really that important? Can’t I just invest in my favorite company?

What is diversification?

You probably know you aren’t supposed to “put all your eggs in one basket,” right? That is talking about diversification. Diversification means investing in a large number of different assets across multiple sectors. Let’s say you want to build a stock portfolio. It is pretty obvious that investing all your money in Ford Motor Co. is not a diversified portfolio.

Your investments will be completely dependent on the fortunes of one company. Ok, so what if I invest in Ford and General Motors? This still isn’t diversified because you have only invested in US automotive companies. If the auto market dries up, your entire portfolio will tank. The key to diversification is to be broadly invested across wide array of investments, both in the US and in foreign countries. They should be like eggs in an Easter basket. All different colors and sizes.

John decided to open a store in Austin, TX. When he first opens during the spring he sells sunglasses. His sales grow and keep getting better as spring turns to summer. Then in the fall, his sales drop off and by winter he is barely making enough to keep the lights on. Nobody is buying his sunglasses during the winter because its raining all the time. In January, John gets an idea to add an umbrella rack to his store. Now his sunglasses still aren’t selling, but he is doing a brisk business selling umbrellas. When spring rolls around again, the umbrella sales die down, but sunglass sales are on the rise. By selling two products that people need during different times, John is able to have steady growth, instead of the roller coaster just having one product caused. This is the idea behind diversification.

What is financial risk?

To explain why diversification and asset allocation are important, we first need to understand risk in the context of investing. When talking about investments, risk is the uncertainty of investment returns. For example, we may say a certain investment is expected to produce an 8% annual return. What we really mean is we expect an average annual return of 8%. Some years it might be lower, some years it might be higher. In statistical terms, the expected return is the mean, while risk is measured by the standard deviation. We won’t go into any math, but just understand that investment returns fluctuate within a range of expected outcomes; they aren’t a set number.

There are two categories of investment risk: systematic risk and unsystematic risk. Systematic risk is inherent in the system and can’t be avoided. Things like the risk of inflation causing prices to increase, short term drops in the overall market causing investment values to drop, and the risk of foreign exchange rates changing are all systematic risks. Unsystematic risk, on the other hand, are unique to a company, industry or country. The risk of a company’s leadership doing a bad job, the risk of a government changing regulations in an industry or the risk of a company over borrowing and defaulting on loans are all unsystematic risk.

What does risk have to do with diversification?

Systematic risk is inevitable. If interest rates change, inflation rates go up, or the whole market drops, everyone will be affected and you can’t avoid it. Unsystematic risk, however, can be mitigated through diversification. Let’s say you build a diversified portfolio. You included stocks from many companies in different industries, including a mix of foreign companies. You also included asset classes other than stocks, like bonds, real estate, commodities, etc. If Company A hires a bad management team and struggles, the rest of the portfolio will balance out the returns. If technological advancements or social change upends an industry, your investments in other industries should help counter-act the negative effect on your portfolio. Therefore, investors want a well-diversified portfolio across a range of asset classes.

If you have any questions about this topic, or have a burning question about a different finance question, feel free to reach out and ask me a question. It might even become my next blog topic. If you would like help aligning your personal finances to achieve the life of your dreams, please schedule an introductory call and I would love to speak with you.