Investing Classroom: Why diversify?

In this lesson, we'll cover what diversification is and what role it plays in building a fund portfolio. Subsequent lessons in this level will discuss how to build a portfolio of funds.

Diversification: What it is
If you're having friends over for a barbecue, would you only serve meat? You'd probably expect more than just protein. Instead, you'd probably offer an assortment—some salad, bread, maybe beer, and so on. In short, you'd diversify your table so that your guests would be satisfied.

Now consider investing. You want to own various types of funds so that your portfolio, as a group of investments, does well. Certain types of investments will do well at certain times while others won't. But if you have enough variety in your portfolio, it is pretty likely you'll always have something that is performing relatively well. Owning various types of funds can help reduce the volatility of your portfolio over the long term.

Let's say that you buy a value fund that owns a lot of cyclical stocks, or stocks that tend to do well when investors are optimistic about the economy. If that were your only fund, your returns wouldn't look very good during a recession. So you decide to diversify by finding a fund heavy in food and drug-company stocks, which tend to do relatively well during recessions. By owning the second fund, you limit your losses in an economic downturn like the one we’ve all been experiencing. That is the beauty of diversification.

Diversification: What it isn't
Diversification isn't a magic bullet.

Having a diversified portfolio doesn't mean you'll never lose money. Diversification doesn't mean complete protection from short-term dips. Diversification does not guarantee that if one investment goes down another investment will go up—it isn't a seesaw.

August 1998 illustrated this point. It was an absolutely wretched time for investors; the average stock fund lost around 15% that month, funds that bought emerging-markets stocks were down twice that as Asia imploded, gold funds slid about 22%. Even bond funds were in negative territory. The lesson: because all sorts of investments can suffer at the same time, your only sure-fire protection against sudden losses is to put some of your assets in a money market fund.

Ways to diversify

Diversifying across investments: Say you owned stock in a single company. If the company flourished, so would your investment. But if the company went bankrupt, you could lose all of your investment. To reduce your dependence on that single company, you buy stock in four or five other companies, as well. Even if one of your holdings sours, your overall portfolio won't suffer as much. By investing in a fund, you're getting this same protection.

Diversifying by asset class: The three main asset classes are stocks, bonds, and cash. Some financial advisers contend that international stocks, real estate investment trusts, emerging-markets stocks, and the like are also asset classes—but the stocks, bonds, cash division is the most widely accepted. Adding bonds and cash (typically considered to be securities with maturities of one year or less) to a stock-heavy portfolio lowers your overall risk. Adding stocks to a bond- or cash-heavy portfolio increases your total-return potential. For most investors, it is wise to own a mix of all three. How you determine that mix depends on what your goals are and how long you plan to invest.

Diversifying by sub-asset classes: Within two of the three main asset classes—stocks and bonds—investors can choose several flavours of investments. With stocks, for example, you may distinguish between UK stocks, foreign developed-market stocks, and emerging-markets stocks (typically considered to be stocks from emerging economies, including Latin America, the Pacific Rim, and Eastern Europe). Furthermore, within your UK stock allocation, you can have large-growth, large-value, small-growth, or small-value investments. You can also make investments in particular sectors of the market, such as real estate or technology. The possibilities for classification are endless and often overwhelming, even to experienced investors.

The bottom line
So what is the bottom line on diversification? Diversifying across investments and by asset class is crucial. Sub-asset class diversification is useful, but not everyone needs to own a government-bond fund, an international fund, a small-cap fund, a real-estate fund, and on and on. You should nonetheless consider the various ways that such investments might add diversity to your portfolio—and allow you to rest a little easier.

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