Financial Concept: Diversification

You’ve heard the sage advice “Don’t put all your eggs in one basket.” That’s diversification. The S&P 500 is an index based on the market capitalizations of 500 large companies having common stock listed on the NYSE or NASDAQ. It is far more likely that one of those companies will go bankrupt in any given year than it is that 100 of them will. Each individual company has its own risks, and most companies can be accurately categorized into one of several different economic sectors, e.g., technology, banking, or mining, each of which is associated with different risks or cyclical trends.

By investing in only a few companies, you remain largely exposed to the “unsystematic” risks (that affect only an industry or a specific company) that each one faces. Conversely, by investing in a pool of different stocks, you lower the risk of a few bad apples wiping you out completely. You will also realize the additional benefit of reducing the overall volatility of your portfolio considering that losses in a diversified portfolio are often offset by gains, and vice versa.

This brings us to the third investment rule: Diversify Broadly.

What you’re betting on is that the combined change in value of all of your shares taken together will, over time, make you money. Historically, that’s been a safe bet. But over a long period, there will certainly be times when you’re down across the board. Understandably, those are tough times, but I will repeatedly tell you that the wisest course of action during those times is to wait and ride out the storm.

Diversifying is investing 101, but it’s easier said than done. Most individual investors lack sufficient resources to effectively diversify on their own. If you wanted to buy shares of 500 different publicly traded companies, you’d need over $2 million, and would incur prohibitive transaction costs. And your basket still wouldn’t include Small Value Stocks, International Stocks, or Bonds.

So Wall Street devised “commingled investment vehicles” that enable multiple investors to pool their assets to spread out their individual risk. Mutual funds, variable annuity subaccounts, and exchange-traded funds (ETFs) are examples of such vehicles. These vehicles achieve greater diversification, allowing individual investors to invest simultaneously in thousands of different stocks, with each investor owning a proportional share of those assets. By pooling assets with other investors, we achieve a far higher degree of diversification than we can alone.