What is Diversification and How Does it Help?

Jun 2, 2022 | Getting Started, Investing, Saving & Investing

If you are an investor, you have likely heard the term “diversification.” However, have you ever asked yourself, “What actually is diversification?” or “How do I achieve proper diversification?” In this article, we will help you gain an understanding of these questions allowing you to be best positioned for success as an investor. 

Often investors mistakenly believe they are diversified because their investment portfolio is divided amongst different people or firms managing their money. Unfortunately, what often happens when multiple investment firms manage money is that investors end up unintentionally creating more risk. Let’s look at how. Firm A buys several large cap growth mutual funds as does Firm B and Firm C. The top 15 holdings of each of these funds are often concentrated in the same stocks. As a result of holding six to nine mutual funds, you are truly creating a non-diversified portfolio that is concentrated in the same 15 stocks. While the intent is to have a diversified portfolio, the result is a portfolio with additional risk because of a concentration in a specific type of investment.

The premise of diversification is that a portfolio comprised of several distinct types of investments blended together in a proper and calculated manner will not only perform better, but will accomplish this with less risk, than a portfolio with fewer investments. Diversification may help protect your portfolio against adverse events that would affect specific investments. For example, when the COVID-19 pandemic first swept around the world in the first quarter of 2020, airline stocks were among the investments that were most negatively impacted. If you had owned the stock of just airline carriers your portfolio would have seen a significant loss in value. However, if your portfolio also held stock in companies that facilitated home exercise (Peloton for example) or home food delivery (DoorDash, among others), the loss to your portfolio would have been mitigated. Diversification does not guarantee returns or protect against losses, but it can help reduce risk within your portfolio. 

Diversification affects risk depending upon the correlation between and among the securities in an investment portfolio. Let’s look at how correlation works by looking at the stock of two companies.  One is an umbrella manufacturer and the other makes sunscreen.  When it rains, the umbrella manufacturer will sell more umbrellas and there is less demand for sunscreen. On the flip side, the more the sun shines, the less need for umbrellas, and more sunscreen is applied.  A negative correlation or inverse relationship exists between umbrellas and sunscreen.

Let’s add two additional companies in the mix, a Wellington rain boot (“welly”) manufacturer and a swimming suit manufacturer.  Because rain boots and umbrellas are often used at the same time and swimsuits and sunscreen go hand in hand, there is a positive correlation between these manufacturers. There are also assets with “zero correlation” to one another.  For example, a cellphone has no correlation with either umbrellas or sunscreen. We don’t use our cellphone any more or less just because the sun is shining or its raining. Zero correlated assets are also part of a diversified portfolio, but to maximize diversification in your investment portfolio you want to have negatively correlated (sunscreen and umbrella) stocks in your portfolio as well. When one stock is out of favor, the other is in favor, thereby reducing the risk of your portfolio.

There are many different components to properly diversifying an investment portfolio. At a basic level diversification must exist across asset classes, investment style, size, industry, and geography. Different asset classes that can be components of your portfolio include equities (stocks), fixed income (bonds), cash and cash equivalents, and real assets including property and commodities. Investment style diversification is your portfolio’s mix of growth and value, while size includes large-cap, mid-cap, and small-cap stocks. Diversification within fixed income might include corporate and government bonds, as well as bonds of various credit quality and duration.  Industry diversification considerations could include energy, technology, financials, etc. Finally, a diversified portfolio would include investments domiciled in the United States, developed international markets, and emerging markets. As you can see, achieving proper diversification is complicated, but with diligence can be accomplished.

Proper Diversification is key to successfully navigating a downturn in the markets. Unfortunately, market volatility and investing go hand in hand. Market pullbacks can be scary for investors and each pullback feels different. However, A properly diversified portfolio tends to stabilize and recover more quickly regardless of the underlying cause. In the long run, being diversified creates a smoother investing experience allowing investors to accomplish their objectives while finding peace of mind along the bumpy ride. 

When applying the concept of diversification to your investment portfolio, it is important to remember that the purpose of diversification is maximizing returns while mitigating risk. Investors who stick with their financial plan, remain invested in a diversified portfolio, and maintain a long-term outlook achieve their goals more often than those who do not.  

A GreenUp Wealth Advisor has the knowledge and tools to help you make sense of diversification, identify an appropriate asset mix, and create a plan designed to help you achieve your financial goals.  Are you ready to get started? Call or email us today.

Author

  • Dennis Goodwin, CMFC®

    Vice President | Wealth Advisor | Kansas City -- Dennis helps clients understand the importance of their financial future and create possibilities through planning and professional advice. Dennis is a Vice President, Wealth Advisor, at Greenup Wealth and brings over two and half decades of financial services experience to the firm. Prior to joining Greenup, Dennis spent eight years as an advisor with one of the largest RIA firms in Kansas City. Dennis’ prior experience within the financial services sector as a sales manager, operations manager, and learning and development specialist, have provided him a great deal of knowledge and experience which he brings to bear in each of his client relationships.

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