Why is Diversification Important? – Trajan King
diversification

Why is Diversification Important?

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diversification

“Diversification is a protection against ignorance. It makes little sense if you know what you are doing.” Warren Buffett

Whether you’re an angel investor or someone looking at a good option to invest your money in, diversification is something you must know about and practice.

More people should know the definition of diversification or how to use the strategy. Most investors only look at traditional options when investing money and they think just having more of something is diversification. They hardly consider investing in non-traditional methods and only stick to bonds and other such options without paying attention to diversification.

The interesting thing about diversification is that it’s everywhere. A diversification strategy can be used in finance, marketing, economics, etc.

In this article, we’ll cover the diversification definition, strategy, and some examples.

Diversification Definition

Diversification is a strategy that can be defined as a technique that involves holding multiple investments that will react differently to the same economic events or market changes.

For example, stocks typically outperform bonds when the economy is going strong. But, when things take a u-turn, stocks begin to crumble while bonds usually hang on strong.

By owning both bonds and stocks, you can reduce the risk of your portfolio taking a major hit when the market begins to swing in one direction or the other.

Diversification involves allocating your investments across several industries, financial instruments, and other categories. The aim is to maximize returns.

However, we must mention that diversification does not only involve investment instruments. It also means the teams that manage your money.

Imagine working with fund managers who all went to Harvard Business School between 1980 and 1990. They might be good at what they do but they’ll most probably share a certain worldview even with a diverse underlying fund.

You have to diversify across different mediums. If you’re looking at stocks, opt for a variety of stocks – tech, finance, travel, etc. If one industry crashes, the other will keep you afloat.

Diversification is a common investment technique, yet most professionals agree that it doesn’t guarantee against losses. It only minimizes the risk. 

Let’s talk about the benefits of diversification for a clear understanding of how it works.

The Benefits of Diversification

diversification strategyHere are some benefits of diversification in finance:

Reduces Exposure

According to the 2019 survey, stocks and related funds made up about 64 percent of total investments in the US. This shows how dependent Americans are on one option. 

Unfortunately, a lot of investors in the country only look at stocks or bonds. Some are not even aware of options like startups, art finance and REITs. They end up with a heavily skewed portfolio that’s exposed to one investment instrument. 

This mistake does not only increases the risk but it also increases exposure. 

Minimizes Risks and Generates Returns

Not all investors have similar goals. Some want to accumulate wealth and some want to preserve capital. Our risk tolerance depends on a number of factors including our age. 

An investor close to the age of 50 cannot typically have the same risk tolerance as an investor in his or her 20s. By diversifying your portfolio, you can reduce the risk of sudden jumps or falls. 

If one investment performs poorly, the other will keep the portfolio balanced and help you achieve financial independence.

Helps the Economy and Pushes Ideas

By investing in startups, you give others the confidence to start a business, which helps the economy. Just make sure to invest your money in a company that looks promising. Moreover, pay attention to the names behind the business. 

The person running the business must be motivated and excited about the idea. Moreover, he or she must have a proven ability to handle business. 

Preserves Capital

Investments do not always perform as expected. Diversifying ensures you have a backup plan if your main source of income fails.

It’s rare for multiple assets with unique sources of return, like precious metals and government bonds, to experience similar declines at the same time. Even if one investment falls 50 percent, the other investment would keep your portfolio from falling that far.

Diversification protects against volatility and guards you against big market shifts. 

While this is the main benefit of diversification, you should look at the opportunity cost of investing in a single asset. 

A lack of diversification may cause you to miss out on good opportunities.

What Are the Risks That Diversification Protects Against?

diversification definitionInvestors have to face two main types of risks:

 

  • Undiversifiable

 

Also called systematic risk, it’s associated with every investment and can be due to external factors like inflation, exchange rates, interest rates, political instability, and war, and interest rates. 

Diversification does not reduce this risk. It’s a form of market risk that investors cannot control because it affects the whole market and not a particular industry.

The situation due to Covid-19 is a type of systematic risk. It’s global and has affected all industries.

 

  • Diversifiable

 

Also called unsystematic risk, it’s specific to an industry or company and can be reduced through diversification. 

Examples include labor issues, weather conditions, etc. Facebook, for example, recently had to face issues due to companies boycotting the platform. The ban caused FB stocks to fall briefly but it did not affect other industries.

Diversification: An Example

Let’s say three individuals have $10,000 each:

  • Mr. A: He invests $10,000 in airline stocks because he loves to fly. He believes airline stocks will grow in value due to increased travel and went for Delta and American Airlines. 

All of a sudden, pilots go on a strike due to political changes. Travel comes to a halt and airline stocks fall – Delta by 30 percent and American Airlines by 40 percent.

In the current scenario, Mr. A’s portfolio is down 35 percent.

  • Mr. B: He’s Mr. A’s friend and he also loves to travel but he believes that railways are going to be big as well. He invests $5,000 in Delta (30 percent down) and $5,000 in railway stocks.

After pilots go on a strike, Mr. B hopes to see his railway stocks increase due to the increased demand but the railway system crashes due to system overload causing railway stocks to fall 20 percent. 

Now, Mr. B’s stock is 25 percent down. His portfolio is better than Mr. A’s portfolio, but it’s not perfect because airlines and railways face similar risks. In fact, they have a very strong correlation.

  • Mr. C: Mr. C decides to opt for portfolio diversification as he believes in creating value through diversification . He invests $2,000 in American Airlines (40 percent down), $3,000 in bonds, $2,500 in biotech, and $2,500 in finance stocks.

Due to the airlines going on strike, his one investment falls but his money in bonds remains strong and his biotech stocks grow by 20 percent, whereas finance stocks increase by 15 percent.

Overall, his portfolio would be able to balance itself. The losses from airlines are being covered by the gains from finance and biotech, while his money in the bonds is secure.

This example shows why it is important to diversify across the board. The more uncorrelated your investments are, the better.

Diversification and Startups: What Does it Offer

Merely knowing what diversification means may not be enough. You should know all about asset diversification, brand diversification, etc.

Diversification is important in investing because it safeguards the investment portfolio. But is diversification really about buying different assets? Not really. Diversification definition makes it clear that it’s about risk diversification and going different routes, i.e.: not putting all your eggs in one basket.

Angel investors seem to have understood the concept. They look for good ideas to create a diversified portfolio. Everyone from Mark Zuckerberg to Warren Buffett have invested in startups that are now worth millions.

Investing in a startup is not the same as being a partner. Angel investors may have the right to go through account books and ask questions but they may not take part in business decisions.

As an investor, you will get your share of profit, which, at times, may take a little while to come since startups can take time to grow.

Study the market to understand how each asset reacts in the same situation. Equity and bond, for example, move in opposite directions. Precious metals do well during a recession, whereas stocks fall. 

In addition to this, remember the importance of location. Look for opportunities abroad. After all, changing political situations in the US may not affect bonds and stocks in Europe.

Diversification Exit Strategy

You know diversification strategy and how to diversify but you also need to have a clear diversification exit strategy. Not all your investments will do well and you will at times have to quit an investment. This is why you must have a clear diversification exit strategy. 

There are five popular exit strategies including IPS, M&As, selling to a friend, making it a cash cow, and liquidating.

The best option depends on factors such as why you wish to liquidate and which asset you’re dealing with.

Diversification Strategy: Conclusion

Finding the right investment can be difficult. It might be a good idea to work with a professional who understands diversification strategy and can help you diversify your portfolio.

Portfolio diversification calculators might be of help but they don’t always work. For the latest diversification tips, check back here and sign up for our free newsletter. That’s where the secrets are. 

 

Michael Wight

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