By Lucas Counts
Diversification is a critical strategy to understand for any and all investors. It’s not quite the “golden rule” of money, but it’s close! Diversification involves spreading your money around into different investments—different asset types, geographic regions, and more—so that your portfolio can better withstand the ups and downs of the market. In effect, it helps mitigate the risks of investing in the stock market.
Just how important is diversification? Here’s an example:
Pedro is 53 years old and is set to retire tomorrow. He’s been working towards this day for 30 years, and finally has the money to do it—he checks his investment portfolio, and sees that he has more than $1 million in assets.
However, over the years, he’s only ever invested in a single asset: Coca-Cola stock. So, his investment portfolio contains more than $1 million in Coca-Cola stock. But the next day, Coca-Cola’s earnings report shows that its sales have cratered. As a result, its stock loses 50% in a single day. (Remember, this is all just an example, and an extreme one at that!)
And Pedro’s portfolio? Also down 50%. He’s lost hundreds of thousands of dollars overnight. It’s because his portfolio was not diversified.
Now, imagine if you had $1 million in a single stock such as Apple, Amazon, or Google. These are stocks that have gained massive value in recent years, so it’s easy to understand why an investor wouldn’t want to buy anything else. But remember: past success doesn’t ensure future success! Just because a Fortune 500 company is tearing up the markets today does not guarantee the same will be true tomorrow.
And that is why diversification is so important.
Diversification: Don’t put all of your eggs in one basket
In a world with GameStops and crypto, we’re all clearly chasing that home run stock, or hoping that our holdings will shoot to the moon! We must not forget, however, that higher potential returns often come paired with higher risk.
So, when you are tempted to put all your eggs into one basket, think twice! It’s always a good idea to think about how diversifying your portfolio can help you hedge against risk.
Here’s another thing to keep in mind: General Electric (GE) was dropped from the Dow Jones in 2018 after a run of over 100 years as one of the most consistent and largest stocks in the world. So, even seemingly secure companies’ value can eventually go downhill. The same is true of other companies, too, like Blockbuster Video, Sears, and myriad others.
Changing markets, changing perceptions by society and consumer tastes, along with company management and other variables can change a company’s future, regardless of today’s circumstances. Keep this in mind—you have no way of knowing what will happen tomorrow, so secure your portfolio by diversifying.
Enron: A diversification story
Let’s use another example to show why diversification is so important to investors. Let’s time-travel a bit back to the late 1990s, and pretend that you’re heavily invested in a hot stock: Enron.
At its peak, the Enron Corporation, a massive energy company based in Houston, Texas, saw its shares trading above $90. In the 1990s, Enron pioneered aspects of energy trading, among other things. Its stock was a hot commodity. But Enron had some serious problems—a whole slew of fraud and white-collar crimes helped it inflate its assets and earnings. It was all an illusion in the end.
Once that all came to light, Enron fell hard. The company declared bankruptcy on December 2, 2001, and just prior to that, its shares were trading at a measly $0.26—a fall of more than 99.7% from its highs.
So, if you had half of your investments in Enron, half of it would’ve been vaporized, and through no real fault of your own. Again, like with Pedro, this is why it’s important to diversify.
How to diversify your portfolio
The simplest way for most investors to diversify their portfolios is to simply stick to buying index funds or ETFs. ETFs are like baskets of investments, such as stocks and bonds, giving investors built-in exposure to numerous companies or industries. That’s a whole lot of diversification wrapped up in a neat little package!
Similarly, index funds track a market index, rather than a single company. So, if you purchased an index fund that tracks the S&P 500, the value of that fund will ebb and flow with the S&P 500, not a single company within it. So, if Coca-Cola or some other company sees a particularly steep drop in its stock price, investors are pretty much unaffected unless the whole market tanks.
But you can also make sure you’re investing in other assets, and there are a lot of them out there. You could buy crypto, for instance, or even precious metals—but fair warning, most professionals will tell you to stay away from those until after you’ve built up a healthy portfolio.
For most investors, though, likely the best thing to do is to stick to index funds and ETFs, since they’re already diversified investments. You can, of course, also talk to a professional about your options.
Just make sure you aren’t putting all of your eggs in a single basket. Make it one of your investing goals.
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