Portfolio diversification is a strategy that makes investing less risky, which reduces your overall chance of losing all your money if the market has a bad day, week, or month. What exactly is diversification? We have all heard the mantra “don’t put all your eggs in one basket,” but what does that exactly mean? Does diversification really add any value to your portfolio?

What is diversification?

When you start investing, most people have a fear of losing money, which stops them from even starting in the first place. The majority find the stock market scary or intimidating, and along with that is a fear of making a bad financial decision. These two things together stop most people from taking the plunge into investing. While this is an understandable fear, it is avoidable with one pro tip of diversifying your investment to minimize your risk. In the simplest of terms, diversification means investing in a range of assets, meaning you are not too concentrated in one or another. This lowers your risk by having other investments that can keep your portfolio afloat if one asset class hits a downswing.

Simple diversification example

You start investing by purchasing one share of Company XYZ for $100. At the end of the first year, the stock lost 50% and you sell it for $50. This means that you lost $50. You give it another go, but the second year, you purchase one share of Company ABC for $50 and one share of Company DEF for $50. The following year, Company ABC drops down by half and you sell it for $25, while Company DEF doubles and you sell for $100. This means that you made $25 because although Company ABC dropped, Company DEF gained to give you a positive return overall.

Psychology of diversification

Upon seeing the returns, you will have some regret not investing all of your money into Company DEF. But this is a regret that most investors will be happy with, as you have increased security with a diversified portfolio. After all, you could have made the wrong decision and invested it all into Company ABC and had a loss. Diversification takes planning and control, just as it takes disciple to not invest your whole portfolio in the latest “hot stock.”

Asset diversification

So you might be thinking, ok I just have to buy a verity of stocks and I am diversified. Though this is good practice, there are a number of different classes of assets which each react in their own way during volatile market conditions. Having the right mix of those asset classes, and ensuring each stock is offset by another is what makes it useful to spread your money. Stocks, bonds, cash and gold are some of the most popular asset classes with all have their own different risks and rewards. Stocks are risky and can have large rewards. Bonds are more predictable and lower risk. Gold varies based on price and can increase during financial crisis, and lastly cash is a safe haven though the returns are poor. Diversifying across those 4 sectors equally will mean diversifying your risk

Protect your portfolio

Diversifying your portfolio gives you protection against financial losses. Structuring your portfolio to anticipate downturns in the stock market will provide greater peace of mind. Although you are not fully invested in the stock market for all the day-to-day rises and falls, you also don’t need to keep an eye on the market 24/7. Diversifying will also protect against becoming complacent with your portfolio and assuming that everything will just carry on as it always has. There are those rare events, such as the 2008 market crash and the market drop seen in 2020 as a result of the COVID-19 pandemic, that sent shockwaves through the stock market. Although a diversified portfolio would not entirely protect your investments, it could have helped against some losses. During the 2008 market crash, a portfolio with real estate, bonds, and gold would have fared much better than a portfolio that was fully invested in real estate.

Investors know that the stock market will go up and down daily, causing fluctuations in your portfolio. It is the investors that are prepared for those large changes who can stay calm when they happen. Diversification is what gives you the best chance of weathering a large downturn in your investments.  You can stay calm, knowing that you have confidence in your portfolio’s diversity. This is one of the ultimate dreams for most investors.