Diversification is one of the most overly-used financial words to make financial advisors seem really smart and intimidating. But financial advisors don’t have to be intimidating at all! (Although I do hope they are smart.) Diversification is one of the most important financial lenses in which to look at your money. As I dive deeper, let me explain (1) What diversification is and why it is important, (2) the different types of diversification, and (3) some examples of BAD diversification. Let’s get started.
(1) What is Diversification and Why is it Important?
Diversification is one of the most important aspects of someone’s personal finance journey. Diversification is, at its core, simply spreading out one’s risk. Remember when you were little and your grandma probably told you to not put all of your eggs in one basket? That is diversification. Putting some of your eggs in several different baskets is one of the most healthy things that you can do in your financial (and more specifically) investing journey.
Let’s break this down a little bit, because this topic can be made unnecessarily complicated by finance professionals and it doesn’t have to be so.
Let’s look at a few hypothetical examples of Adam, Chris, Kevin, and David. They each have $10,000 to invest and all invest differently.
Adam really likes Netflix. In fact he likes Netflix so much that he is going to invest all of his $10,000 in Netflix stock. If Netflix does well he will have gains in his investment of Netflix. Woo hoo! But what if something really bad happened? What if Netflix went out of business because some new company came into the marketplace and did a much better job than Netflix at a lower price? Adam would lose ALL of his money! Ouch.
Chris also invests in Netflix but he also likes Walmart and wants to invest in them as well. He invest’s $5,000 in each company. That means that if Netflix went out of business he would lose $5,000 instead of Adam’s $10,000 loss. Ouch, but to a lesser extent.
Kevin also invests in Netflix and Walmart. He also likes UPS and decides to invest in them as well. He invests $3,333 in each company equally. That means that if Netflix went out of business, he would lose $3,333.
David also invests in Netflix, Walmart, and UPS. He also decides to invest in Google. He invests $2,500 in each company equally. That means that if Netflix went out of business, he would lose $2,500.
| Person | Amount Lost |
| Adam | $10,000 |
| Chris | $5,000 |
| Kevin | $3,333 |
| David | $2,500 |
Of the four people, Adam is the LEAST diversified and David is the MOST diversified.
Diversification helps you as an investor protect yourself against loss. When you have several different investments, then you spread out your risk and protect yourself against loss.
This is a beautiful thing!
The more investments that you have, the more you will be diversified.
Think of diversification as medieval body armor. The more diversification you have in your investments, the less likely you will be to lose substantial amounts of money. Likewise, the more diverse areas of a knight’s body are covered with armor, the less likely he will be struck down.
You may be asking yourself, “Does this mean that if I am diversified, I can avoid losing any money at all?”
The answer is no. No matter what, whenever you invest in something, there is an element of risk. Some investments are not risky at all, like a CD at your bank or a Treasury Bond. And some investments are extremely risky like a lottery ticket or a naked short sale. (Don’t worry if you don’t know exactly what these are, just know that there are some investments that are more risky than others.
The other important thing to remember is that the more risk you take the higher the reward for taking that risk can be. That also means that if you take very little or no risk you will also have very little or no reward. It is a trade off that I will explain in more detail in another article.
The most important thing that you can take away from this article is that the more investments you have, the more diversified and protected from loss you will be.
(2) Examples of Diversification
There are several different ways that you can gain diversification in your investing portfolio. The biggest way is similar to the example above of Adam, Chris, Kevin, and David. If you invest in more companies, you will be more diversified.
But there are a TON of ways to gain diversification. You can invest a combination of investments like:
- Individual stocks
- Individual bonds
- ETFs
- Index funds
- Mutual funds
- REITS
- Rental real estate
- CDs
- Collectibles
- Art
- Cryptocurrency
- Personal residences
- Land
- Businesses
- Cash
- Sports cards
- Target-date funds
- International stocks
- Dividend stocks
- And several others
And within each of those, there are probably hundreds or thousands of ways that you can become even more diversified. The possibilities are nearly endless!
(3) Bad Diversification Examples
If you think that diversification is good, then intuitively you should think that the lack of diversification is bad. You would be correct. While there is certainly a time and place for less diversification (such as owning a small business), for the vast majority of investors, a lack of diversification is NOT a good thing.
Bad diversification can look like several things:
- Having no investments but a home that you own free and clear.
- Owning stock in only one or two companies.
- Having only one stream of income.
- Owning only cryptocurrency.
- And several others.
Do what you can to stay as diversified as possible!
Final Thoughts
Diversification is one of the most important factors in investing that we all need to understand.
If you find yourself in a place now where you are not very diversified (or not diversified at all), that is okay. There is no need to panic. Just work your way into a place where you are more diversified over time.
If you realize that all of your money is invested into one investment, you may not have to sell that investment right away in order to purchase others and achieve some level of diversification. Just stop buying any more of that investment and start purchasing other investments. Over time you will become more diversified.
I am here to help you. If there is anything that you would like to know more about please let me know in the comments.
And as always, please share this article with a friend.
🙂
Until next time!
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