Diversifying Your Investments - Why is it Important?

Diversifying Your Investments - Why is it Important?

For those invested in the financial markets, one of the most commonly used words regularly encountered is “diversification.”  But while many with exposure to stocks, bonds or commodities understand that diversification is a good thing, but what might not so readily understood is why this is true.  There is a great deal of wisdom in the saying that “you should never put all your eggs in the same basket,” as there is no better way to protect your investments from external shocks and market volatility.   

Diversification in Income and Investments

The idea of diversification itself is much simpler than attaining the ability to complete the process accurately.  Diversification simply means to spread your investment exposure over a broad range of asset types and market sectors, and this is the best way to ensure any of your investment goals are not obstructed by unforeseen outcomes in the financial markets.  But there are different types of diversification, as well - in income and in investments.  When dealing with income, greater diversification come when your income comes from more than one source (for example, from areas other than just your salary).  When dealing with investments, diversification comes when market exposure is seen in more than one (and ideally a wide variety) of financial instruments (rather than just a single stock or bond). 

Structuring Your Portfolio

“When looking at the topic of diversification,” said Kris Alban of InvestingIQ, “the main goal is to structure your portfolio in the strongest, most stable fashion possible.”  The range of available asset classes include potential holdings in areas like stocks, bonds, real estate, precious metals, commodities, and even currencies themselves.  Within those categories, we have even broader options to diversify.  For example, should you buy a single stock or a stock index (such as the S&P 500)?  Should you buy US stocks?  European stocks?  Stocks in emerging markets?  These are all possibilities to consider when looking to structuring your portfolio strategy.

Reasons to Diversify

As a real-world example, imagine you had invested all of your saving in the US stock market in 2007.  This was when market valuations were reaching all-time highs and just before the collapse of Lehman Brothers.  Clearly, an investment decision like this would have been catastrophic as the value of your investments would have fallen by more than 30% in the following year.  If, however, you practiced diversification in your portfolio strategy by placing half of your money in US bonds, those losses could have been limited to just over 17%.  Other areas like precious metals (gold, in particular) could have been used for additional diversification. 

And since gold prices rallied significantly in the period that marked the collapse in stocks, most of the potential portfolio damage could have been avoided altogether.  So, while the market volatility seen after 2007 created little in the way of desirable market conditions, there would have been ways of limiting your potential downside if some simple market rules were initially followed.