Investing is a game of minimizing risk and maximizing reward.
As investors, we want to choose investments that can make us the most money over time (and avoid investments that lose us money).
While this goal is simple in theory, there is no such thing as certainty in the investing world.
An investment that looks incredible on paper could turn out to be a dud, and an investment that looks subpar could be a home run.
So, how do investors deal with uncertainties and unknowns?
What is Diversification?
The term “diversification” is self-explanatory.
It refers to diversifying your investments – aka not putting all of your eggs in one basket.
An investment portfolio with a single stock is not diverse and, therefore, 100% susceptible to the fluctuations of that single stock.
An investment portfolio with 25 stocks is diverse and susceptible to the fluctuations of multiple stocks.
Let’s discuss why the latter is a safer bet.
The goal of diversification is to hedge risk by combatting the unknown.
As mentioned above, there is no such thing as certainty in the world of investing. Every great investor knows this.
If you purchase a single stock, your entire investment performance is based on that stock.
If that stock performs well, you make money.
If that stock does not perform well, you lose money.
At this point, you may be wondering, “why can’t I just choose one REALLY good stock?”
While that’s a great idea in theory, it exposes you to a lot of risk.
First, you are relying on your ability to pick an exceptional stock that will outperform the market. This is difficult for even the most experienced investors.
Second, you can’t predict the future. Unforeseen events may turn a winning stock pick into a loser (i.e., company struggles, new competitors, tech disruptions, market corrections, etc.).
Individual stock picks can be lucrative, but it’s never wise to put all of your eggs in one basket.
Let’s use a coin-flip analogy to illustrate the point.
We know the odds of a coin flip are 50/50.
You receive the following generous offer – win $200 if it lands on heads and lose $100 if it lands on tails. Similar to a good stock pick, that’s a bet worth taking, right?
Well, if you flip the coin once, you have a 50% chance of being right (making $200) and a 50% chance of being wrong (losing $100).
So, even though you’ve identified favorable odds, you can still lose $100.
If the bet is only taken once, you can walk away with less money than you started with.
But, what happens if you flip the coin 100 times?
If the theoretical probability of 50/50 holds true, you make $5,000 ($10,000 in winnings – $5,000 in losses).
Even if you only win 40% of the time, you still make $2,000 ($8,000 in winnings – $6,000 in losses).
The point is that multiple bets are safer than a single bet, even with favorable conditions.
Investments are the same.
Diversification helps you spread risk across a variety of investments to decrease volatility and shield you from uncertainties that can impact your investments.
Instead of making one bet on one investment, you are making multiple bets on multiple investments, increasing your odds of success.
Ways to Diversify Investments
The first way to diversify your investments is through ETFs, or “exchange-traded funds.”
ETFs, like mutual funds, are baskets of different investments that can be purchased as a unit.
For example, SPY is an ETF for the S&P 500, which gives you exposure to 500 stocks.
When people advocate for “investing in index funds,” they are essentially advocating for diversification.
While an investment in an S&P 500 ETF is technically a single investment, it is comprised of 500 different stocks, which smoothes volatility and protects investors from being overexposed to a single stock.
ETFs can also be used to make “bets” on a variety of themes/ideas (vs. companies). You can use sites like ETFDB to find ETFs for a variety of themes ranging from industry to sector to region of the world.
These generalized bets give you some more wiggle room with your investment theses.
For example, assume you do your research and expect the semiconductor industry to experience massive growth in the coming years. If you bet on a single stock, your performance is tied to a single company. If you purchase an ETF instead, your performance could be tied to the sector itself (without having to predict which companies will be winners and losers).
Betting on a theme/sector/broader market is often much safer than betting on a single company. While you may limit some of your potential upside, you are also limiting your potential downside.
Furthermore, you are increasing the probability that your initial investment idea will pan out as expected. Think about it – which of these bets would you feel more confident in:
- Betting on the growth of the health food industry over the next decade or betting on the growth of a single healthy restaurant chain?
- Betting on the growth of AI technology over the next decade or betting on a single AI company?
Every ETF you invest in gives you exposure to a basket of investments, which is a simple way to diversify.
Of course, you don’t need to invest solely in ETFs. In fact, ETFs can be used to hedge some of your individual stock picks.
Take the example above, where we discussed the semiconductor industry. Let’s assume you find two companies you really like. You could always invest in those two companies AND a semiconductor ETF just in case you picked the wrong winners in the industry.
We just discussed how ETFs can be used to invest in “baskets” of stocks instead of individual companies. However, individual stocks still play an important role in many investment portfolios.
With regards to diversification, the goal is to spread out risk across a variety of different companies in different industries.
For example, if your portfolio consists solely of Apple stock, your investment performance is 100% dependent on the performance of Apple.
If your portfolio consists of Apple, Google, Nvidia, and Microsoft, you have started to diversify across companies, but you are still heavily dependent on the performance of the technology sector.
It should be noted that this isn’t always a bad thing. Investors may be okay with being “overweight” in a certain company or sector. They recognize the “high risk, high reward” nature and accept it.
If that fits with your investment strategy and risk tolerance, that is okay too. There’s no reason to diversify just for the sake of it, especially if that leads you to start investing in stocks, ETFs, and asset classes you are unfamiliar with.
That said, if you want to mitigate risk, you may consider investing in multiple stocks in multiple sectors.
There are infinite ways to go about picking stocks, so we’ll leave you with a few resources that may help:
- The Motley Fool Stock Advisor (Easiest Solution)- Great for getting new stock picks and recommendations every month.
- Seeking Alpha (For Research-Driven Investors) – Great for researching stocks and reading the opinions of other investors.
- Stock Rover (For Portfolio Analysis) – Great for analyzing different stocks, seeing how they fit in a portfolio, and gauging how that portfolio performs over time.
- 2 Fresh Stock Picks Monthly
- 20-Year Track Record of Beating the Market
- Instant Access to Top Starter Stocks
Other Asset Classes + Portfolio Allocation
Investors may also choose to diversify out of stocks and ETFs, limiting their exposure to public markets.
Below is a list of some other potential investments:
- Bonds and bond funds
- Money market funds
- High-interest savings accounts
- Real estate
- Starting a business or investing in an existing business
When considering both stock/ETF investments and alternative investments, it’s important to consider risk/reward so you can match your portfolio allocation to your risk tolerance and conviction in an investment.
Let’s take Bitcoin as an example since cryptocurrencies have been popular in recent years. In it’s strongest year, Bitcoin returned 5,507% (2013). In it’s weakest year, Bitcoin returned -73% (2018). That type of volatility is enough to drive even the most levelheaded investor crazy.
Cryptocurrencies are notoriously volatile, and many view the investment in cryptocurrencies like Bitcoin as a binary decision – to invest or not to invest? Investors range from die-hard believers (HODLers) to investors who simply want exposure.
So, how do you get some exposure while minimizing your downside? Minimize your portfolio allocation.
A highly volatile investment may not be palatable if it comprises 50-80% of your portfolio, but what if it was only 5-10%?
This isn’t intended as a recommendation to buy cryptocurrency or any speculative investment. It simply highlights the point that portfolio allocation can be used to manage risk and reward.
This is the same logic behind the classic 60/40 portfolio (60% stocks, 40% bonds). The stock allocation is used to capitalize on the growth potential of stocks, while the bond allocation provides some stability. Investors may take that a step further by adding allocations for a variety of different assets.
Of course, portfolios may also be rebalanced over time based on market conditions. Investors may not want to add cryptocurrencies when they are already up 5,000% on the year, but may consider easing into positions when they are down 50%. Similarly, investors may avoid holding cash when interest rates are low, but opt for a higher allocation when rates are high (5%+ at the time of writing this piece).
When determining your portfolio allocation, it’s important to consider the following:
- Your Capital – If you are investing with $10,000, you may not spread it across as many assets as you would if you were investing $1 million. You may also be more open to riskier investments, considering a 20% drop in a $10,000 portfolio equates to $2,000, whereas that same drop in a $1 million portfolio equates to $200,000 (same percentage, but far more money)
- Your Risk Tolerance – Can you stomach riskier investments? Risk tolerance varies by investor due to both psychological reasons and phase-of-life reasons. Younger individuals may be able to take on more risk than those close to retirement. That said, just because you can take on more risk doesn’t mean you want to.
- Your Expertise – Diversification for diversification’s sake is foolish, especially if it leads you to stray outside of your comfort zone and areas of expertise. If you don’t understand real estate investing, you shouldn’t be buying properties. If you don’t understand cryptocurrencies, you shouldn’t be investing in Bitcoin.
- Your Time Horizon – Your investing timeframe impacts the investments you choose. For example, history shows that the stock market always goes up over long periods of time (20+ years). This is comforting if you have a 20+ year time horizon, but less so if you are retiring next year. The S&P 500 is in a long-term uptrend, but it has experienced 50%+ drops along the way. Consider when you are going to need your cash and what your risk tolerance is along the way.
- Market Conditions – Market conditions may also impact your portfolio allocation. For example, if real estate prices skyrocket, it may not be the best time to add properties to your portfolio. If real estate prices plummet, it may present an opportunity. Conventional investing wisdom recommends that investors avoid trying to time the market, but it’s still important to know what you own so you can identify investments at fair value.