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About 4 minutes
Unless you’ve been living under a rock (or under a pile of brightly colored candy eggs), you’ve probably heard people talk about diversification. However, the details aren’t always explained, so we’re here to help.
What is diversification?
Diversification is all about spreading your bets. As the old saying goes, you shouldn’t put all of your eggs in one basket. If you spread your eggs across multiple baskets, you’ll be less likely to break them all at once. We aren’t entirely sure who carries their eggs in baskets, but the idea is an important one, especially when it comes to investing.
When you invest your money, you are taking on some financial risk. The value of your investments can go down. But when you diversify by spreading your money across a number of investments, each particular investment only represents a small portion of your wealth. So if one runs into trouble, the majority of your wealth will still be secure.
But diversification also protects your wealth in a slightly more subtle way too.
Reducing swings in your investments
In addition to protecting you from a single bad investment, diversification can also help you reduce the fluctuations in value of your investments (some days your investments will go up and some days they’ll go down).
Let’s see how it works with an example.
Suppose you have $100 to invest, and you have three choices.
1) You can invest it all in Stock A
2) You can invest it all in Stock B
3) You can invest some money in Stock A and some money in Stock B
Don’t worry if you aren’t quite sure what a stock is. We’ll cover the specifics of stocks and other types of investments later.
For now, let’s suppose Stock A and Stock B each cost $50 per share. Since you have $100, you can either buy two shares of Stock A, two shares of Stock B, or one share each of Stock A and Stock B. This is what your three choices would look like graphically.
Let’s suppose Stock A and Stock B are expected to earn the same return.
Again, ignoring the details for now, this simply means there’s no way of knowing which stock will perform better. Let’s also say they are equally risky. So you would be indifferent between owning Stock A or Stock B.
Now it’s one month later, and the prices of the stocks have changed. The price of Stock A has decreased to $45 per share. And the price of Stock B has increased to $65 per share.
If you had bought two shares of Stock A, your $100 would now be worth $90 (two shares worth $45 each). Had you bought two shares of Stock B, your $100 would be worth $130 (two shares worth $65 each).
If you had bought one share of each, your $100 would be worth $110 ($45 plus $65). You would have clearly done better if you had owned two shares of Stock B, but you also would have done worse if you had owned two shares of Stock A.
If the prices had been flipped and Stock A was now worth $65 and Stock B was worth $45, the outcome would be exactly reversed. See the image below. But you would still have $110 if you owned one share of each.
And remember, we said there was no way of knowing in advance which stock would do better, but by buying one share of each, you would have reduced your chances of losing money.
In fact, all three of these scenarios have the same expected return, but the choice of owning one share of each stock has the lowest expected risk. This makes it the best option to choose of the three.
Beyond two stocks
This example was intentionally simple to illustrate how diversification works, but the idea can be extended into more realistic scenarios. In general, you can reduce the swings in value of your investments when you diversify.
Over any given period of time, some of your investments might decrease in value, but others might increase, helping to offset the decline in your overall wealth.
Alternatively, you might have a situation where all of your investments are decreasing in value. But some might decrease less than others, which will also help to reduce the swings in your wealth. As long as your investments aren’t perfectly correlated (which would mean they move in perfect lock step with one another), you can reduce your investment risk by diversifying.
This section is really just the tip of the iceberg in terms of how diversification works and we’ll cover more details in the sections on investing.
1) Diversification is about spreading your money around and can help protect you from a single investment going badly.
2) Diversification can also help reduce the fluctuations in your wealth over time.
3) As long as your investments don’t move in perfect lock-step with one another, diversification can reduce your risk.
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