Defining Diversification

In the top few responses most people give when you ask what they know about investing, “it’s important to be diversified” is right up there with “buy low, sell high”. Both statements are true and very important components of investing. My concern is that we hear and say these things so often, we lose sight of what they actually mean.

Investopedia.com defines Diversification as “a risk management technique that mixes a wide variety of investments within a portfolio.” True, but what the heck does that mean? Can it be any mix of investments? What does it really hope to accomplish? Is my portfolio diverse?

Today my goal is not to sell you on a particular investment strategy or convince you that there is any one way to properly diversify. My hope is to provide some key educational points to enhance your understanding of this important rule of thumb.

As the last several years have shown, investing in the stock market can be a volatile experience. If you invest in stock in one or even a small handful of companies, the value of your portfolio can shift wildly, often it seems for no logical reason. The primary purpose to diversify your investments is to decrease these and other risks.

How does one increase a portfolio’s diversity? Let’s look at a portfolio strictly invested in stocks. The simple answer is to buy a higher number of stocks. The better answer is to buy a higher number of different kinds of stocks. Suppose you own General Motors. Buying Ford might technically make you more diverse, but only slightly so. You still own just two companies, both large, US automakers. Instead, you should look at a vast array of companies differing in size, location and type.

This means expanding your portfolio to large and small companies of all types (often called sectors) all across the globe, avoiding the urge to own more companies in the U.S. than in other parts of the world. U.S. companies make up just 40-50% of global market share. By focusing solely on the U.S., you cut off the opportunity to better diversify and participate in the opportunity for growth in more than 50% of the world’s companies.

I want to stress that none of this is a blueprint for any type of investment strategy. It is simply an effort to help you understand what diversification means. How much diversification, in what areas, and the blend or allocation of different types of assets is a decision that should be made with careful thought and, in most cases, professional advice based on your goals and ability to tolerate risk.

As you approach your personal financial planning and goals, it’s important to obtain at least a basic grasp on the essentials in order to make the most educated decisions possible. There are lots of trusted professionals there to help, but knowledge is always a worthwhile investment.