Whether you’re an experienced investor or only planning to start investing, it’s common knowledge that to be long term profitable, you must either create an investment strategy or follow a pre-existing one. Among other popular investment strategies, investment diversification is one of the rather simpler ones. Yet, it’s proven to be effective, especially in mid-to-long-term investing.
What exactly is investment diversification?
More often than not, when we hear about successful investors, it’s usually about how they’ve made millions upon millions from ‘striking gold’ or made a lucky investment. Unfortunately, luck like that is reserved for only the.. well, lucky. Or people who devote their lives to studying markets and how to make money by investing.
For others, however, it’s useful to remember two idioms:
- Don’t put all your eggs in one basket;
- In this world, nothing can be said to be certain, except death and taxes.
In essence, what this means is to profit in the long-term, it’s important to not put all of your ‘eggs’ or assets in a single ‘basket’ or investment vehicle. Because even a stock that has done very well over an extended period may become volatile or crash entirely due to unforeseen reasons.
A perfect example would be airline stock growth over the decade up to 2020. Right until late 2019, air travel was a globally booming business. But, after the pandemic hit, airline stock across the world rapidly dropped in value. Some of these airlines perished to the global crisis, and out of those who persisted, many still struggle to recover. However, shortly after air travel was suspended across the world (along with any type of travel, really), airlines that specialized in freight skyrocketed in value.
An investment within the travel industry in the Q1 of 2020 would’ve quickly decreased in value. Diversification would have lessened the impact of the pandemic in this case, if the investor would have also invested in freight carriers.
Mostly, though, diversification means investing in different industries, to reduce risk more effectively. So, if you don’t account for hindsight, instead of investing in both passenger and freight airlines, it would make more sense to invest in air travel and a large telecommunications company, for example. Just in case, when there’s a halt in global travel, you can make back some money from humankind’s extensive use of personal devices and the internet.
Can diversification be effective for you?
It really depends on a single factor. Do you spend or intend to spend a very significant amount of time in asset research and monitoring? If the answer is no, then using one or more conventional strategies is definitely for you. Diversification falls right into that category.
In the words of Warren Buffett, “Diversification is protection against ignorance”. And that’s not meant as an insult, either. You see, for someone as well-versed as Mr. Buffett, diversification may not make any sense.
But, for those of lesser experience and knowledge, who simply wish to generate increased returns on their investments, diversification gives a chance to eliminate some of the risks typically associated with investing, without having to spend too much time and energy following and learning every single detail about the market. The aforementioned risks can be put in two categories:
- Systematic. Risks that fall across all industries. War, inflation, pandemic, interest rates pertain to this category. These risks, unfortunately, cannot be mitigated.
- Unsystematic. Risks that are specific to industry. For example, an air traffic controller strike has a direct impact on the aviation industry. These risks can be reduced by using diversification.
For diversification to be most effective, the most conventional view states that the desirable amount of investments lies between 15 and 20. Yet, if you’re just starting on your ‘invest quest’, having a few different stocks or other assets can help you increase your overall returns and reduce the overall risk you take on.
To increase the diversity of your portfolio, it makes sense to not only invest in stocks from different industries, but also take on different asset classes as well. For instance, think about having stocks in various industries in your domestic market as well as the international market. On top of that, look to add some bonds, both corporate and government-issued.
Besides, it’s also important to understand that diversification does not remove risk entirely. As with any type of investing strategies, lower or higher risk is simply something you’ll always have to live with. And the cumulative effect of your portfolio’s diversity still depends highly upon your capability to choose the better investment assets.
On top of that, diversification may be more expensive than simply putting all your money in very few assets. This is due to the fact that different assets in different markets also have different transaction costs. For instance, fees and charges pertaining to buying and selling.
Diversification is a solid investment strategy that works very well for investors that don’t have the knowledge or patience and time to acquire said knowledge. This strategy helps you reduce the risk you take on when investing. While diversification does close to nothing for systematic risks like war and inflation, it does help with the unsystematic risk category that is industry-specific.
If and when you decide to diversify your investment portfolio, remember to not only invest across industries, but different types of assets also. Stocks, bonds, cash and real estate are some of the more regular asset types, the combination of which can help mitigate unsystematic risk and increase the return on your investment portfolio.