Portfolio Diversification

Portfolio diversification is a form of portfolio risk management. By not "placing all your eggs in one basket," you minimize the potential for loss due to unanticipated risks associated with any single investment. The old proverb warns us not to depend entirely on one particular thing and that we should diversify our resources and efforts across multiple baskets instead.

What Is Portfolio Diversification, and Why Does It Matter?

Portfolio diversification is a technique that investors use to reduce their risks by investing in various assets. By spreading their funds across multiple asset classes, investors can minimize any particular investment's impact on their portfolios.

However, it is crucial to remember that diversification is not the end-all guarantee against losing money. Still, it can help reduce the risks associated with owning a single asset or group of assets. By placing your eggs in multiple baskets, investors further protect themselves against the risk of any single investment going bad.

As with every investment decision, it is essential to consider the risks and rewards associated with the investment before making any decisions. All investments present an element of risk. However, diversifying one's portfolio can reduce the overall risks and improve their chance for long-term success.

A well-diversified investment portfolio is vital to protect your savings from volatility in the markets. By investing in various asset types, you can reduce the risk of losing money if one of your investments declines in value. For example, if all of your money is invested in stocks and the stock market crashes, you would likely lose more money than if you had spread your capital among stocks, bonds, and cash. Diversification also helps to reduce the risk of investing in a single company. If that company goes bankrupt, you could lose all of your investment. However, if you invest in multiple companies from different sectors, the risk of one of those companies going under and wiping out your portfolio is reduced.

The Basics of How to Diversify a Portfolio

There is, and likely always will be, much debate over the best portfolio strategy. While there are many popular portfolio strategies, investors can simply follow, the one thing they all do is spread their eggs across multiple baskets. Meaning they invest in a variety of securities so that the weight of each holding is small. Regardless of the particular portfolio strategy you employ, you should always keep your own personal investment goals in mind.

One option to diversify your portfolio is to invest in stocks from different countries. This can be done by investing in a global stock mutual fund or exchange-traded fund. These funds invest in stocks from around the world, so you can benefit from the growth of different economies.

Another option is to invest in stocks from different industries. This can be done by investing in a sector mutual fund or exchange-traded fund. These funds invest in stocks from various industries, so you can benefit from the growth of different sectors.

Simply keeping cash on hand is yet another way to diversify your portfolio. By keeping a portion of your portfolio as cash, you can take advantage of rare opportunities in the market, such as a black swan event, a market correction, a particular IPO, or some other once-in-a-lifetime opportunity. Cash is also highly liquid, which means it can be quickly accessed in an emergency.

While there are many asset classes investors use to diversify portfolios, such as cryptocurrencies, bonds, commodities, and infrastructure, the important thing is that no individual investment makes up the majority of a portfolio.

Over Diversifying a Portfolio

The flip side to not placing all of your eggs in one basket is carrying too many baskets. An overly diversified portfolio means that no single investment has an opportunity to flourish. While diversification is crucial, if your capital is spread across too many assets, and one of them is immensely successful, it will have a negligible impact on the overall portfolio. For example, if you have $1,000 invested evenly into 50 stocks at $20 each, and one of them boasts a 1,000% home run return, that investment would be worth $200. Not terrible, but the argument is that if you had diversified across only, say, 10 assets, that 1,000% return would instead be worth $1,000, doubling your money off a single investment.

What Is the Ideal Number of Stocks to Invest In?

The ideal number of stocks and other assets you should invest in is up for debate. Some investors will claim a specific number like 30. Other investors might advocate for a more focused approach of 5 to 10. As always, it's essential to consider your own investment goals, such as your time horizon, risk tolerance, liquidity requirements, and other needs. Keep in mind that as the number of assets in a portfolio grows, so does the time sink required to perform proper due diligence.

Summary

Diversification is paramount to the long-term success of any investor. This advice is consistently repeated by top investors. The saying "don't put all your eggs in one basket" is often used when discussing portfolio diversification. However, investors should also be wary of over-diversification and not try and carry too many baskets or not have enough eggs to place in them. The question of which asset classes and how many you should diversify into is subjective. Each investor has individual investment goals, and different assets perform differently depending on the current economy and market cycles.