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The Importance of Diversification


Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximize return by investing in different areas that should each react differently to changes in market conditions.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

Different Types of Risk

Investors confront two main types of risk when investing:

Undiversifiable

Also known as "systematic" or "market risk," undiversifiable risk is associated with every company. Causes are things like inflation rates, exchange rates, exchange rates, interest rates, political instability and war. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification; it is just a risk that investors must accept.

Diversifiable

This risk is also known as "unsystematic risk," and it is specific to a company, industry, market, economy or country; it can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so that they will not all be affected the same way by market events.

Diversification does not guarantee a profit or protect against a loss in declining markets.

Why You Should Diversify

Say you have a portfolio of only airline stocks. If it is publicly announced that airline pilots are going on an indefinite strike, and that all flights are cancelled, share prices of airline stocks will drop. Your portfolio will experience a noticeable drop in value.

If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance that the railway stock prices would climb, as passengers turn to trains as an alternative form of transportation.

But you could diversify even further, as there are many risks that affect both rail and air, because each is involved in transportation. An event that reduces any form of travel hurts both types of companies—statisticians would say that rail and air stocks have a strong correlation.

Therefore, to achieve superior diversification, you would want to diversify across the board, not only different types of companies but also different types of industries. The lower the correlation of your stocks, the better.

It is also important that you diversify among different asset classes. Different assets—such as bonds and stocks—do not typically react in the same way to adverse events. A combination of asset classes should reduce your portfolio’s sensitivity to market swings. Generally, the bond and equity markets move in opposite directions, so if your portfolio is diversified across both areas, unpleasant movements in one will likely be offset by positive results in another.

There are additional types of diversification, and many synthetic investment products have been created to accommodate investors’ risk tolerance levels. However, these products can be very complicated and are not meant to be used by beginner or novice investors. For those who have less investment experience, and do not have the financial backing to enter into hedging activities, bonds are often the most popular way to diversify against the stock market.

Unfortunately, even the best analysis of a company and its financial statements cannot guarantee that it won’t be a losing investment. Diversification will not prevent a loss, but it may reduce the impact of performance below expectations.

How Many Stocks You Should Have

Obviously owning five stocks is better than owning one, but there comes a point when adding more stocks to your portfolio ceases to make a difference. There is a debate over how many stocks are needed to reduce risk while seeking a high return.

The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries.

Conclusion

Diversification may help an investor manage risk and reduce the volatility of an asset’s price movements. Remember though, that no matter how diversified your portfolio is, risk can never be eliminated completely.

You can reduce risk associated with individual stocks, but general market risks affect nearly every stock, so it is also important to diversify among different asset classes. The key is to find a medium between risk and return; this helps ensure that you achieve your financial goals while still getting a good night's rest.


Diversify across the board, not only different types of companies but also different types of industries. The lower the correlation of your stocks, the better.


Investing involves risk, including possible loss of principal.

Diversification does not guarantee a profit or protect against a loss in declining markets.

AMG Distributors, Inc., is a member of FINRA/SIPC.

 

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