You’ve probably heard the word diversification a few times before — it’s become a bit of a buzzword, but it’s really quite simple. Within the context of finance, diversification refers to the process of investing your money in distinct places in such a way that decreases exposure to risk.
Diversification is important for protecting your hard-earned money. As an analogy, imagine if you kept all of your money in physical cash, in a safe in your house. If a robber breaks into your house and steals the safe, he’ll have all of your money! But if your money is split up in 5 different safes, each in a different location, the robber can’t get all of your money by stealing the one safe.
By investing your money in multiple places, you’re reducing the chances of your portfolio losing significant value in a short period of time. While one asset might drop in value, the chances of 5 completely different assets losing value at the same time are much lower.
There are 5 unique ways you can diversify your portfolio. No one is superior to the other, but a healthy combination of at least a couple of them will help make your portfolio rock solid.
An asset class is a group of investments that have similar characteristics. Stocks are an asset class — Apple Stock and Google Stock have very similar characteristics — they both grant you a portion of the company you’re investing in. Other asset classes include Bonds, Real Estate, Cash, and Precious Metals (Gold and Silver, for example).
Typically, asset classes have various behaviors and risks associated with them. Stocks typically have higher returns, but also carry a high risk of loss. Cash is very stable but will lose value with inflation. Bonds are in the middle in terms of risk-reward. Diversifying across asset classes will give you a good spread of risk so you’re never losing too much at one time if your riskier investments, such as stocks, drop.
Currency is an all too often overlooked area for diversification. Currency refers to the value of the local money in a particular country. For example, in the United States, we have the US Dollar or USD for short. In many European countries, they use the Euro. In Japan, it’s the Japanese Yen.
Currencies can fluctuate in value just like any other investment. In 2002, 1 Euro was worth about $1 USD. In 2007, it shot up to $1.45 USD. By May 2020, it’s sitting at $1.10 USD. If the US economy does well, you’ll need less USD to buy Euros — and vice versa if it does poorly.
By purchasing investments in various currencies or just holding cash in them, you gain more protection in your portfolio from economic problems in the countries whose currency you used to invest.
You may have heard the advice (if not, I’m telling you now) to never time the market.
If you’re aiming to buy low and sell high, then you need to be right twice: calling the bottom of the market and calling the top. But how will you know for sure that those things have happened in the moment that they occur? You might buy in right before the market drops, or sell right before it skyrockets. It’s impossible to predict these things.
That’s why many skilled investors recommend a technique called Dollar Cost Averaging (DCA). With dollar-cost averaging, we’re acknowledging the fact that it’s difficult to time when to buy-in. So instead of doing that, you spread your “buys” across time. If you have $10,000 to invest, you would invest for example $2000 every month rather than putting in $10,000 all at once. If the market dips at some point, you’ll be able to buy it at a lower point next month anyway. If the market rises, you’ve already bought in at least a bit with your $2000 so you’re not completely missing out on the big gains.
A market in the world of finance refers to any marketplace where the trading of assets occurs. In terms of diversification, we’re aiming to invest in various markets around the world. There are many to choose from; the New York Stock Exchange (NYSE), Tokyo Stock Exchange (TSE), Shanghai Stock Exchange, London Stock Exchange, and many others across the world.
Spreading your investments across a few of these markets will ensure two good things.
First, your investments are diversified from the countries’ economies — if Europe’s economy tanks, it’s not a big deal because you have investments in American companies too.
The second part is the companies in each area and the people they serve. The markets in India have mostly small-cap companies while those in the United States and their corresponding indexes are heavily weighted towards big tech companies. They also serve different customers and operate in different ways. This uniqueness is your diversification.
Any single industry is highly correlated within itself.
During the COVID-19 Pandemic, businesses in the food, retail, and travel performed extremely poorly, because of fewer people using their services. Every single company in those industries did poorly — they’re all highly correlated. Yet, the stock prices of healthcare and technology companies have gone up and overall remained strong.
Companies within the same industry are highly correlated. But, as in the example above, companies in different industries can have little to no correlation at all. As such, it’s critical to have at least some diversification across industries. That way, you’re protected against the financial slumps in poor-performing or dying industries.
“How many millionaires do you know who have become wealthy by investing in savings accounts? I rest my case.”
— Robert G. Allen
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.