Diversification is the practice of spreading your investment dollars among many types of investments. The idea behind diversifying your investments is that it spreads your risk: if one of your investments loses value, the others won't necessarily lose money at the same time, thus balancing out your risk to some extent. While having a diversified portfolio is usually a wise practice, any investment strategy comes with risk. However, the benefits of diversification generally outweigh the risks of diversification.
Balancing Out Risks
When you diversify, you reduce the risk in your portfolio. Each individual investment carries a chance that it could be a great success, a great failure, or something in between. Spreading your money out limits your exposure to great failures.
If you invest all of your money in a company that turns out to be a failure, you could lose all of your money. If, however, only 20 percent of your money was in that company, you'd still have 80 percent of it working for you.
Lowering Overall Volatility
The other benefit of a diversified portfolio is that, if it is properly structured, you should have less volatility in the overall portfolio. One of the keys to diversification is to select assets that have very low correlations. For instance, if you invested all your money in different oil companies, that would not be very diverse, because if one company did especially poorly or well, the others would often follow that same trend.
It might be more diverse to have some money in unrelated investments, such as foreign oil and domestic pharmaceuticals. Oil prices and drug prices are probably less closely correlated than the prices of two oil companies. While doing this reduces your potential returns in good times, it also reduces your losses in bad times, and increases your peace of mind. This is the very definition of diversification.
Missing the Big One
The safety that diversification brings also carries a downside. It's a good idea to spread your risk between multiple investments in case you pick wrong. On the other hand, if you pick a great investment and spread your money out, you lose the opportunity to completely benefit from that investment.
Diversifying carries the risk of diluting your gains as well as your losses. For example, if you own 50 stocks and one of them doubles, it only amounts to a total gain of 2 percent in your overall portfolio, rather than 100 percent.
False Sense of Security
In addition to systematic risk factors that affect highly diverse portfolios, many seemingly diversified portfolios aren't really that diverse. A portfolio holding stock in American Express, Caterpillar, Intel and McDonald's might appear diverse since it's exposed to four different companies and industries. However, it consists of 100 percent stock in Dow components, and they are all US-based.
Even a more diverse portfolio -- like one holding a small cap stock, a commercial bond from a blue-chip company, and a certificate of deposit at a US-based bank still has exposure to currency risk from the US dollar. As such, true diversification can be hard to come by.
Higher Transaction Costs
One of the downfalls of diversification is that it may cost more by way of transaction fees. If you only buy a couple of stocks and hold them forever, your total commissions will be low. However, if you buy a 50-stock portfolio and constantly buy and sell shares to keep your original asset allocation intact, your transaction fees can eat up a lot of your return. If you choose to have an expansive, diversified portfolio that you constantly update, it's best to operate through a low-cost broker or via a platform that charges you an annual fee rather than a per-trade commission.
Video of the Day
- Duncan Smith/Photodisc/Getty Images