Investing can feel like a gamble, but it doesn’t have to be. By understanding and implementing effective strategies, you can take control of your financial future. One of the most crucial strategies for any investor is diversification.
The idea of investing your hard earned money in stocks is daunting. Every beginner investor has nerves about the market crashing and their portfolio dropping to zero. While this is a very real risk with modern-day investing. Luckily there are rules and strategies you can follow to stop you from losing your hard earned cash. The risks of investing can be the stuff of nightmares. But diversification is here to put your mind at ease and help you sleep a little better at night.
- What is Diversification?
- How can Diversification be Implemented?
- The Benefits of Diversification
- The Disadvantages of Diversification
- FAQ: Diversification
- Don’t want to miss out?
As we get taught when we are younger, “putting all your eggs in one basket” is often a bad idea. The popular idiom refers to the fact it is unwise to rely on a single plan or idea. Putting all your effort and resources into one idea can make it all the more frustrating if it fails.
With investing the idiom takes on a new meaning, albeit a rather important one. Putting all your money in one stock leads to increased risk. Should something happen to the chosen stock, your money can disappear, diversification however can mitigate this risk. Protecting both your money and your profits.
What is Diversification?
So what is diversification? Diversification is essentially making sure your eggs are spread reasonably across many baskets. Or put in investing terms, ensuring your money is spread reasonably over different stocks and industries. Reducing the overall risk of you losing money.
Experienced investors will spread their investments across many stocks, businesses, industries, etc. Even the most successful millionaires and billionaires often owning many companies. While this can seem as though they are starting companies impulsively. It is often to protect their capital should a company go bankrupt. Take Elon Musk for example.
While Elon Musk is currently best known for owning Tesla, he also owns 5 other companies. Including SpaceX, Neuralink and The Boring Company. If owning 6 companies simultaneously is not impressive enough. Over the course of his career he has owned a total of 11 companies.
Should any of these companies go bankrupt, or suffer from catastrophic failure. He has the remaining 5 companies to fall back on for income. Demonstrating just how important diversification can be when managing risk.
How can Diversification be Implemented?
Many experienced traders follow the 70/30 rule. But what does that mean for us exactly? The 70/30 investment strategy refers to a portfolio that allocates 70% of its capital to stocks. With the remaining 30% to fixed-income securities, such as bonds. The goal of this strategy is to achieve high returns while managing risk.
Stocks are considered to be higher risk but higher reward. They are often favored by younger investors. Younger investors often aim to maximize capital gains early in their career. They are often working with lower investment values. Meaning they can afford to take a larger percentage loss on their portfolio than older investors. If their portfolio suffers a significant percentage loss, they can often recover these losses. They achieve this recovery over the course of their investing career. Effectively, accepting the increased risk for the promise of an increased reward.
When owning stocks, no more than 5% of your invested capital should be held in any one stock. This rule helps to effectively spread your capital over the market. Also, no more than 20% of your portfolio should be invested in any one industry. Protecting you if an industry should suffer from a market decline.
Bonds are considered to be much safer investments when compared to stocks. Bonds are a loan that a government or company issues to raise money. The issuer pays a fixed return over a set period of time in the form of interest. Bonds have maturity dates at which the principle amount must be paid back in full. Bonds are often used in pension investments to mitigate risk.
Bonds often have a lower percentage return when compared to many stocks. Due to the fixed interest rate they offer, they are often chosen by older investors. When considering retirement the potential for investment losses can be devastating. The security bonds offer, often puts minds at ease, protecting capital for retirement
While the 70/30 stock to bond split is a reasonable suggestion. It is important for investors to take their own circumstances into account. Choosing a diversification strategy that works for them. This can depend on age, risk aversion and income.
The Benefits of Diversification
1. Protects Capital from Stock Decline
Diversification can protect capital from decline of individual stocks by spreading it out across the market. This prevents large losses in capital should any one stock lose value.
Spreading capital across various industries also prevents from losing capital due to changes in the world. For example for the past 10 years the tech industry has been booming. An investment would have made a healthy return. An investment in the newspaper publishing industry made at the same time would have resulted in disappointing returns.
This is due to real world changes over this time. For example in 2014 only 60% of people in the UK owned a smartphone. Now in 2024 this statistic is over 94%.
As a result of the tech industry booming, many people get their news from digital sources. Causing a decline in the newspaper publishing industry. Showing the growth of one industry can lead to the decline of another. Which industries do you think will grow over the coming decade?
2. Increased Potential for Growth
Spreading your capital across the market means you invest in more stocks. The more stocks you invest in, the more probable it is that one experiences astronomic growth. While this may seem trivial, it is an important lesson when it comes to investing.
The S&P 500 is a popular index fund that tracks the 500 most successful companies in the United States. The S&P tracks how these companies are doing overall. If most of the companies increase in value, so does the S&P. It includes giants like Apple, Microsoft and Amazon. While the S&P tracks the top 500 most successful companies. 90% of its profit comes from only 20 of its stocks. These 20 stocks grow so much, they outweigh the other 480 to give 90% of the index’s profit.
Investing in many stocks can increase the odds of picking a high earner. One that outshines the rest in your portfolio.
3. Smoother Returns
When your investments are spread across different assets, the overall performance of your portfolio is less volatile. The performance of one asset does not affect the portfolio as much due to the large spread.
Imagine you have only invested into one single company. If that company goes bankrupt, you lose all of your money. Now imagine you invest in a mixture of companies, in a variety of industries. If one company or industry struggles, your losses will be offset by the gain of the other companies and industries.
While diversification can not guarantee profits, it can smooth the ups and downs of the market. Providing a stable return for many years to come.
The Disadvantages of Diversification
1. Increased Complexity
With all the benefits diversification brings, it can also bring an increased complexity to your portfolio. It is not always easy choosing a diverse range of stocks in uncorrelated industries. Keeping the stocks profitable, with reliable companies is another challenge entirely.
While this can result in an increased time to begin your investing portfolio. It is well worth the time to set up. Many investing platforms such as Trading212 have tools to aid with diversifying. Trading212 allows for the creation of pie charts, automatically dividing your money between various stocks of your choice. Allowing for an easier method of tracking how your choices are performing.
Alongside this, you can view pie charts created by other investors. Seeing how risk is being managed in their portfolio. While you should not copy these investors blindly, it can be useful to gain an understanding of how diversification looks.
2. Higher Costs
Investing in multiple stocks can prevent higher initial costs than investing in just one. Many platforms will charge a transaction cost while buying stock. Purchasing a wider range of assets results in a larger amount of transaction costs incurred.
While these costs can reduce your profit, they are often very small when compared to the size of the transaction. They are usually a worthwhile sacrifice when considering the money that can be lost without due to poor risk management. While also considering the gains that can be made from spreading capital across many assets. Quickly outweighing the downsides of the transaction fee’s.
3. Identifying Truly Uncorrelated Assets
Identifying assets that have no correlation can sometimes be difficult. Stocks and industries can have links between them that even those with the best foresight can miss. For example, in 2024 McDonald’s suffered from an outbreak of E. coli due to contaminated onions on their burgers. As you can imagine, this resulted in a reduction of their profits. Causing their stock price to fall by over 7%. McDonald’s also happens to be a massive distributor for Coca Cola. While Coke had no involvement over the E. coli outbreak, their share price fell by 14%.
This shows how stocks can be linked in unexpected ways. It often requires vigilance with trial and error to invest in a truly diverse portfolio. Making a truly diverse portfolio comes with experience and research. The value of this experience and research is immeasurable. When considering the profits you will make over the course of your investing career.
FAQ: Diversification
1. What is Diversification?
Diversification is spreading your capital across multiple assets and industries to reduce risk. The bigger the variety in your asset allocation, the more diverse your portfolio will be. A crucial strategy for risk management.
2. What are the Advantages of Diversification?
The more diverse your portfolio the less risk you carry. The more stocks and industries your capital is spread across, the less volatile your portfolio will be. One stock in one hundred holds far less weight than one stock in ten.
3. Are there Disadvantages with Diversification?
Yes, diversification can make your portfolio more complex to manage and set-up. In the long run it is well worth the increased complexity and set-up time.
4. Can a Portfolio be Diverse with Low Capital Investment?
Yes, portfolios with low capital can be just as diverse as any portfolio. Many platforms have a minimum transaction fee of £1 or $1. If investing to ensure no more than 5% of your capital is in any one stock. You would only need to choose 20 stocks. With a minimum investment of £20 or $20.
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