I want to clear up a term that I think is commonly misunderstood by a lot of people when it comes to investing: Diversification. A scary word for what is actually a pretty simple concept, when you get down to it.
What most people think diversification means
Generally, when I talk to people about investing, I hear many tell me that their investments are diversified. “Oh I know all about diversification,” they announce proudly.
“Great!” I respond. “So what do you have your money invested in?”
“I’m invested in ten different energy funds!” They proclaim.
“So… all your money is in energy… in one industry within one country?”
“Yes, but TEN different funds.” As if repeating that statement somehow settles things.
And see that’s the common misunderstanding I run into in my conversations. Most people think that diversification is all about investing with different companies, to minimize the risk of one of them going out of business. That’s not entirely wrong, but it misses the bigger picture by a longshot.
Let’s take a deeper dive into why.
What Diversification Actually Means
Buying different stocks within an industry is one way to diversify, no doubt. But holy crap. There are so many others! To help illustrate why you should care about this, picture your investment performance as a series of wavelengths:
The middle line represents the overall performance of your portfolio. The peaks and valleys represent the highest and lowest returns of your portfolio as time passes.
Now, pay attention here, because this is important to everything else that comes next: the goal of diversification is to reduce the size of those waves. I’m going to stick it a fancy box so that it sinks in.
The goal of diversification is to reduce the size of the overall highs and lows of your portfolio.
This is a basic visual representation of the ultimate goal of diversification:
The line itself (your average return) doesn’t change; it’s only the best and worst performance that shifts. Your highest highs aren’t so high, and your lowest lows aren’t so low. Make sense? Awesome; you understand the basics of diversification. Now that we know what we’re after with this whole thing, let’s look at the different ways of getting there.
Remember the example I gave earlier? This is where many peoples’ knowledge of diversification begins and ends. Again, it’s a valid method, which is why it’s in this list. As you’re about to see though, it’s one of many.
To reiterate, stock diversification involves picking different stocks within a single industry, to minimize your chances of losing everything if a company goes under. All other things equal, if you invest in five companies that perform exactly the same way, and one goes under, you only lose 20% of your investment instead of the full 100%.
Easy peasy, so on we go to the next method of diversification.
Industry diversification involves investing in various stocks across different industries. The thinking here is that different industries react to different market forces, so one industry might do well when another struggles.
Here’s an example: take two different products, luxury cruises and Kraft dinner. When are luxury cruise companies likely to perform best? My guess would be when the economy is booming. They wouldn’t do so well during a recession, which, and I’d like a drum roll here please… is where Kraft Dinner absolutely shines.
So in this example, while one of your stocks is on the upswing, the other is on the downswing… but you never have both declining the same way at the same time. Again, I’m simplifying here, but that’s the gist of it.
Investment Vehicle Diversification
Stocks are only one type of investment vehicle. You can put your money in damn near anything: bonds, real estate, mortgage lending, mutual funds, the list goes on. You’ll have to do some separate research on each of those, but for now, suffice it to say that different types of investments move in different ways. Exposure to multiple types is another form of diversification.
You can also invest across multiple global markets. I live in Canada, but I don’t only invest in Canada. We all know damn well that different economies often have booms and recessions at different times, and while every industry in an entire country can slow down all at once, it’s less likely that that will be the case across multiple countries (still happens, but it’s less likely).
Those differences are why geographical diversification can be a great idea in the long term.
This is just a fancy term for dollar cost averaging, which is itself a fancy term for “investing little bits of money consistently over time.”
Too many people try to time the market. They think they can beat the system. What often ends up happening, though, is they jump in right when the market is at its peak. Then it crashes, and they lose tons.
Well guess what? If you put the same amount of money away each month, then you’ll be putting in when the market is high, low, and everywhere in between. This alone is enough to change your view of a down market. It goes from “ah crap, all my money is way down!” to “Hey, everything in the market is on sale right now, my money this month is going to get me even more!”
That’s the power of dollar cost averaging. That’s the power of diversification across time.
A Quick Recap
I gave you a bunch of tools you can use to diversify your investment portfolio just now. Ultimately though, it all comes down to one thing: you want to pick investments that move in different directions when responding to the same market force.
This is a big oversimplification, but in a perfect world, if my goal is to earn a 6% return, I’d pick two (or 20) different investments that average 6%, but move in different directions. So for example, when interest rates rise, half the funds increase, and the other half decrease, resulting in an average 6% return. Same for when interest rates fall. What I’m shooting for is a portfolio that more or less does the same thing overall, no matter what the broader economy does.
Wrapping it Up
Diversification sounds like a lot of work, doesn’t it? Well, it doesn’t have to be. There’s a type of fund that does all of the things I just talked about automatically: the index fund. I’m not going to get into that here though; for more reading on the subject, The Canadian Couch Potato has a ton of great material. Check ‘em out.
I’ll leave you with one note: if you’re reading this while sitting on the sidelines and not saving anything at all, and are nervous about where to begin, just start anywhere. Saving anything at all, and investing just about anywhere, is better than saving nothing because you’re not sure where to begin. Open a savings account and start there if you really need to. But just get saving, because it’s your future!
The usual disclosure: I’m not a financial advisor, and you shouldn’t take this article (or any other I write) as gospel on the subject. I’m just a normal guy who happens to be passionate about personal finance. SO, that said, do you have anything to add to what I wrote here? Any other tips on how to diversify or what it is? Share them in the comments!