The Power of Diversification
If I had a dollar for every time I heard “don’t put all your eggs in one basket”, I’d be coming close to Warren Buffet numbers. However, analogies that are repeated nonstop often contain a lot of truth. Diversification seems to just protect your overall portfolio performance when a certain stock/industry has an off day, but the truth is, diversification is an absolute necessity in every portfolio.
Think about it... What if 100% of your money was in Cisco (CSCO) when the dot com bubble busted. Over 70% of your money is gone, what a nightmare! Versus, if you only had 10% of your money in CSCO during the 1999 disaster, you would still have 93% of what was originally invested (assuming no prior gains). Now that we know the damage control that diversification can prevent, let’s dive into everything diversification!
Types of Diversification
The prior example of diversification left a huge gap, with 90% of your money in... what? That’s the caveat of diversification; it looks different for every type of investor. For some, this means putting 60% into government bonds and treasury bills, and for others, 50% for naked options, or simply just making sure your investment portfolio is evenly split between all stocks. These are all types of diversification. So, dividing your assets can look like any of the following:
Asset Class Diversification (stocks, bonds, real estate, cash)
Sector Diversification (tech, healthcare, energy, etc.)
Geographic Diversification (U.S., emerging markets, developed international)
Company Size Diversification (large-cap vs mid/small-cap)
Alternative Assets (crypto, gold, private equity, etc.)
None of these are better than the other, but there’s a high chance one or two fit your style a lot more than the rest. As we commonly say at Monk... Make investing your own!
Benefits of Diversification
As previously mentioned, diversification is a necessity more than a common recommendation; it protects your portfolio from uncertainty. More than this, however, diversification enables smoother and more predictable gains over the years. I’ve seen dozens of people online invest all their buying power in one stock, which creates a rollercoaster graph with 20% swings, for a whopping 1% return in a year. Why put yourself through that torment? Is diversification more boring than “yolo-ing” your life savings? Definitely. But does it bring the same anxiety? Absolutely not.
This brings me to my final benefit for diversification, the removal of emotion based trading. When people fire off 20 trades a day while constantly watching the market, they are obligated to make some bad decisions in the heat of the moment. Imagine... You’re driving in your car on a short trip, and somebody cuts you off. You’re fed up and cut around them, then brake check them; stupid and reckless. Now, inversely, you’ve got cruise control on during a long road trip. Someone swerves into your lane? No big deal. Your portfolio is supposed to absorb bumps and unpredictable events; it doesn’t need you to put the pedal to the metal.
What They Won’t Tell You About Diversification...
Diversification also has a dragging downside that most glance over. I’ve mentioned how diversification is damage control, but what does it do to enhance your gains? Nothing, it may even hold your portfolio back a little. However, while diversification may hold your portfolio to a minimal percentage, it potentially saves your portfolio from a detrimental loss. You also should be wary of what some call “diworsification”, or putting too much capital into similar assets. There is a line of diversification, and it can be taken too far, to where you minimize your return drastically. However, this is much more tolerable than the inverse. Make diversification a norm, not an idol in your portfolio.
Warren Buffett famously said, “You don’t need to be right about every investment – you just need to not be wrong all at once”. Let this article be a call to action for you to review your portfolio and diversify. Your finances are a marathon, not a sprint; let this show true in your investments.
The CSCO example from the dot com bubble really drives the point home. So many people forget that Cisco was once valued higher than any company in the world and then lost most of that value almost overnite. The concept of diworsification is also worth keeping in mind though, since spreading too thin can dilute your returns to the point where you might as well buy an idex fund.