The Importance of Diversification

I’m sure many of you have heard about stocks and investing in them. But did you know that there are a multitude of different types of stocks you can invest in? Or that investing in diverse stocks is key in increasing your chances of making a profit? Continue reading this post to learn about the importance of diversification and a detailed example. 

So first, what is diversification?

The Investopedia definition of diversification is, “Diversification includes owning stocks from several different industries, countries, and risk profiles, as well as other investments such as bonds, commodities, and real estate.” So let’s break this down. Diversification is essentially investing in different types of stocks, such as the ones listed above. Instead of holding shares in one company, such as Apple, diversification means to hold shares in multiple different companies. It also includes holding shares in different types of stocks such as real estate, bonds, and companies. 

What is an example of diversification?

I’m sure many of you have heard of Berkshire Hathaway CEO and chairman, Warren Buffet. One of Warren Buffet’s investment strategies is a prime example of diversification. Let’s dissect his strategy. 

Invest 80-85% of your money in mutual funds. 

Investing your money in index mutual funds is where a company takes money from multiple investors and invests that money in different assets. So essentially, they are doing the hard work of diversification for you. By investing in multiple different assets they are bringing diversity to your portfolio and the best part is, you won’t have to manage all your shares in those assets. The best fund to invest in as a beginner who is aiming to bring diversification to their portfolio, is the S&P 500 index which tracks the 500 largest companies on the stock market in the United States. An investment management company, such as Vanguard, will take the money you want to invest and invest it in the S&P 500 which consists of a multitude of companies. This also brings diversification to your portfolio. 

Invest the remaining 15-20% in bonds. 

Investing your remaining money in bonds will bring an added level of security to your investment, as it is typically a lower risk investment. That being said, this is not necessarily always true and there are different risk hierarchies within bonds themselves. It is always crucial to research about the company/asset before investing. Investing in bonds brings diversity to your portfolio and can be less risky than stocks. 

If you want to learn more about this investment strategy in detail, check out our post on How to Invest Money. But keep in mind that this is only one example of diversification. There are a plethora of different, and albeit more complex ways you can bring diversification to your portfolio. The best way to find out what’s right for you, is to do some research on what type of investment you want, the risk you are willing to take, and how comfortable you are in managing multiple assets. 

Why is diversification important?

So why is diversification a crucial aspect in building a profitable portfolio? Diversification helps reduce the amount of risk you face while trying to receive the greatest profit. For example, investing $100,000 in apple stocks is extremely risky. You are risking losing a large sum of money for a potentially large profit, which is EXTREMELY risky. However, investing that $100,000 over diverse assets decreases the risk you are exposed to, while still maximizing your return.  

However you decide to create your portfolio, it is crucial to broaden your knowledge and research before investing. Knowledge about the company you are investing in, is the most effective strategy in mitigating risk.