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What is stock diversification?

What is stock diversification?

Diversification means not putting all your energy or resources into one area.

13 January 2020 · 2 min read

The idiom “don’t put all your eggs in one basket” is an oft-quoted phrase relevant to many life areas. It captures the ultimate risk-averse sentiment: the fear of losing it all from putting all your energy or resources into one area.

Whether you’re dating or job hunting, many heed this advice and avoid betting on one thing. It's also a generally accepted investing mantra about diversifying your assets and investments.

Why diversify your investments?

You could reduce investment risk

If you invest in one type of grocery chain, you’d make a fortune if it came good. But if it went belly up, you risk losing all your money.

Let's say you manage investment risk by diversifying across a few grocery chains. In this scenario, you're better protected against risks facing those individual companies. Yet you're still exposed to vulnerable risks in the broader grocery sector.

To tackle this, you may want to diversify again. You could explore investing in a different industry or country to spread your risk.

You could avoid money loss

By having varied investment types, you're not exposed to one main asset, as per the grocery store example above. This means you might be less likely to lose money if a particular asset or sector underperforms.

You can manage uncertainty

We don’t know how businesses will perform, how customers will react, or how a country’s economy will grow or slow.

By applying diversification, it can act as a hedge against the unknown.

How do you achieve diversification?

By making many varied investments instead of one.

This way your investment performance is not tied to one asset class, industry, company or region.

What are the limitations of diversification?

Even though diversification can be a useful hedge against risk, it is not foolproof. And it does not eliminate risk altogether.

The potential upside may be capped

Just as diversification can limit your downside by smoothing out risk and volatility across a group of investments, it can also limit your potential investment upside.

It can be time consuming to diversify

A diverse portfolio can be more onerous to manage than a less diversified portfolio. This is because there are likely more investments to track and trade, and more things to track.

The fees

Applying diversification usually means holding more investments. This could translate to more fees and overall costs to run the investments, as well as more frequent trading.

What do the professionals advise?

Diversification is something you hear time and time again when it comes to investing. It's a commonly accepted investing mantra, yet not everyone agrees.

Professional investor and billionaire, Warren Buffett says: “Diversification is a protection against ignorance. [It] makes very little sense for those who know what they’re doing.”

Buffett is saying if you know how to pick good investments, diversification is unnecessary.

Perhaps rather than it being an either/or option, it is a mix of both.

The key is really about finding good investments. And once you have honed your expertise and picked good investments with healthy and reliable returns, try diversifying across them.

If you’re new to investing or want help on your investment journey, you may consider seeking the advice and support of a professional like a financial adviser.

The information in this article is prepared by Spaceship Capital Limited (ABN 67 621 011 649, AFSL 501605). It is general in nature as it has been prepared without taking account of your objectives, financial situation or needs.

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