In today’s glamorized world, the all-in or all-or-nothing mentality sounds far more alluring or dramatic. But when it comes to investing, at least safe investing, putting your eggs all in one (or only a few) baskets is perhaps the most dangerous move you can make.
I’m sure you’ve heard the sensational stories of someone investing only a few hundred or few thousand dollars on some obscure cryptocurrency or hot stock like Tesla, then seeing the value of their investment skyrocket to eye-watering levels. Those are the stories the media loves to pick up and highlight because they’re full of excitement, adrenaline, and huge payouts. They’re the type of move that most investors would never have the courage to try (and rightly so).
But boring investing is like the story of the tortoise and the hare. In their race, the hurried hare actually loses because he is in the game for quick wins and quick spurts, much like the risky investor dreaming of a stock going to the moon in a short amount of time. But ultimately, it’s the tortoise whose slow, steady, calculated movements wins the race.
But what does that actually look like in the investing world? In a word: diversification.
If you’d like to watch a summarized video of this article, check out my video below:
WHAT IS DIVERSIFACTION?
Diversification is the concept of NOT investing too heavily in any one thing, whether it be a single stock or cryptocurrency or even a single sector, such as technology or pharmaceuticals or banking. By spreading out your investments into multiple different stocks, sectors, or assets, the theory is that if you catch a truly bad break on one (or a few) of your investments, it will not wipe out the vast majority of your portfolio. You can live another day, lick your wounds and slowly earn more money to invest again later. If a few of your investments lose money, chances are other of your investments will be profitable. The chances of the majority of your investments losing money is exceedingly slim if you’ve properly diversified.
To become truly diversified, you should expose yourself to as many different types of investments as possible. This could mean splitting your money between stocks, bonds, real estate, business, and cryptocurrency. So say the stock market in general is having a terrible year because of a severe recession. If you’ve diversified and also have some investments in a small business, perhaps that business is thriving, so the returns (profits) from that investment can make up for the losses in the stock market.
Or let’s limit our discussion to just stocks alone. Even within the stock market itself, we can diversify. Instead of putting in 90% of our available money into a hot stock you’ve read all about, everyone on Youtube is raving about, and have been recommended to you by numerous friends, you could diversify by purchasing 10 different stocks. That way if 2 or 3 of them crash, 3 or 4 them stay relatively flat, and 3 of them increase in value, you won’t lose significant money. You may even be overall positive since the winners balance out the losers. It’s a safer way to invest.
No one can consistently and accurately predict the stock market, so it’s a lot like gambling if you believe those expensive stock brokers who promise you above-market returns year after year. Despite their fancy business degrees, decades of investing experience, proprietary trading algorithms and analyses, these “experts” all fail to beat the market for extended periods of time. Simply put, no one has a crystal ball or Magic 8 ball to know—with strong certainty—if a particular stock will increase or decrease.
Spreading out your money allows you to participate in a basket of opportunities, and it’s unlikely that ALL of them will fail.
How you diversify and how much you allocate into different assets or asset classes is largely up to you and your personal risk appetite. But most savvy investors have strong diversification throughout their investment portfolio.
STYLES OF DIVERSIFICATION?
Let’s look at a few different styles or types of diversification.
1) Diversified asset classes: This is the broadest type of diversification in which you split your money across different TYPES of investments, such as stocks, precious metals (gold, silver, etc.), real estate, bonds, cryptocurrencies, and more. Today, you can invest in virtually anything even if you cannot own the thing outright. For example, traditionally, it was difficult for individual investors to invest in multi-family dwellings like massive apartment complexes because those were millions and millions of dollars that the average investor doesn’t have. But by pooling investment capital from many investors together, there are now platforms that allow fractional investments, so everyday investors can put up a much smaller amount of money and still get exposure to these investing opportunities.
While there is often correlation between certain asset classes, such as stocks and real estate generally moving together in the same direction either up or down, while stocks and bonds often have an inverse relationship, the more you are able to expose yourself to different TYPES of investments, the safer you will be. You may not see the eye-water levels of returns (say above 20% per year), but you should be able to enjoy a relatively safe and steady 4-10% per year, depending on exactly how you spread out your money.
Many investors like to split their money between stocks, bonds, and real estate—perhaps the three most popular investment assets.
2) Diversified across industry/sector in stocks: When people talk about investing, stocks is often the first and easiest way to get started. Stock investing is a mature market, so you have a wide selection of industries you can invest in, including biotechnology, machine learning/AI, automotive, space exploration, oil and energy, banking, retail and home consumer goods, agriculture, electronics and computing, and pretty much anything you can imagine. As long as the company is a publicly traded company listed on a stock exchange, you can invest in it.
Obviously, some sectors are more risky than others. For example, space exploration and tourism is a relatively new and unproven market. If you invest in that industry and it happens to take off and become popular, you’ll win big. If not, you will lose significant money. So it’s inadvisable to invest too heavily into just that one risky industry.
What if you spread out your money across multiple (ideally unrelated) industries? Then if one of them doesn’t perform well, hopefully the others do.
The danger is thinking you are diversified when you are still picking companies within the same sector. For example, if you invest in GM, Ford, and Tesla, you are diversified across different automakers, but what if the ENTIRE automotive industry is taking a hit? Then all three of your investments will be losing.
Even if you think a bit broader—say technology stocks, which is a wide swatch of industries—that entire area could be taking a hit during a recession, so it would be wise to also simultaneously invest in industries that people still need in difficult economic times, such as agriculture. No matter what, people need to eat.
3) Diversified across individual stocks: While it is more risky to invest in several stocks all within the same industry, if you truly believe in the future of that industry, it could be worth it to concentrate your money more heavily on those stocks. Let’s say you believe that electric cars are the future, so you begin investing heavily in EV (electric vehicle) makers like Tesla, NIO, and XPeng. You’re not so confident that you can pick the ONE winning company, which is why you invested in 3 similar companies. If your prediction about the EV industry is correct, then all three stocks will likely rise (or at least the big winner will outweigh the losses). This is still considered diversification—just on a smaller scale because you run the risk of the entire industry failing.
That’s why it’s often smart to pick stocks across multiple, unrelated industries (which goes back to point number 2 above).
EXAMPLE CASE STUDIES OF DIVERSICATION (check out the math)
So far we’ve been talking high-level abstract theory. Let’s put this into concrete numbers so you can really see the dangers and benefits.
Let’s say you have $10,000 to invest.
A non-diversified investor might be a huge believer in Amazon, so he puts 100% of his money into Amazon stocks. Let’s say at the time of purchase, each share of Amazon is $100 flat. So with $10,000, he can purchase 100 shares of Amazon.
Bull case (profitable): let’s say Amazon has an amazing year, so the share price now rises to $150. Each share (originally $100) can now be sold for $150, which nets a $50 profit each. We have 100 shares, so the total earnings is $50 x 100 = $5,000, or a 50% return. That’s very impressive! Unfortunately, unless you happen to pick your stocks right, the chances of this happening are very slim. More than likely, you will LOSE money or at least be far less profitable.
Neutral case (slight profit): let’s say Amazon has an average year. Nothing spectacular. The price after 1 year is only $105, a $5 profit per share. So with 100 shares, you’d make a profit of $500, which is a 5% return. It’s still profitable, but it’s not considering opportunity costs (what you COULD have earned by investing in something else instead).
Bear case (losing money): let’s say some bad news happens at Amazon that sends the company into a tailspin. Maybe their sales are significantly down during a recession and no one is shopping online anymore. Now the $100 share is only worth $60 at the end of the year. That’s a loss of $40 per share, x100 = $4,000 loss, or a negative 40% return. You put your eggs all in one basket, so you’re really hurting. You have no other investments to take the edge off this extreme loss. That’s the danger of NOT diversifying. Sure, the potential gain could be huge, but so is the potential loss. Most investors cannot accept such devastating losses, so they prefer to take a lower (but more assured — though nothing is 100% guaranteed) return by diversifying.
Now, let’s analyze a more diversified investor with the same starting $10,000.
Let’s say he wants to invest in 5 different stock industries, so he invest $2,000 each.
Pretend the automotive industry sees a gain of 10% over the year, so his $2,000 becomes $2,200, which is a profit of $200.
Then say the agriculture industry sees a gain of 20%, so that’s a profit of $400.
Then assume the luxury retail goods industry sees a loss of 10% because it’s a recession and people can’t afford discretionary goods as much as before. So that’s a loss of $200.
Then say the AI industry sees a huge boon and posts a whopping 40% gain, which gets you the investor a profit of $800.
Finally, we have another loss, say in the education sector. Maybe it’s a 5% loss, so a loss of $100.
Add everything up:
+$200 automotive
+$400 agriculture
-$200 luxury retail goods
+$800 AI
-$100 education
———————-
TOTAL: $1,100 profit (11% return on the original $10,000)
That’s not bad! Compared to the non-diversified Amazon investor who could have made $5,000 or lost $4,000 (both of which are not as far-fetched as it might seem), the diversified investor has a smaller but safer return. Obviously, his 11% gain is not guaranteed either, but it’s more guaranteed than Amazon alone being profitable.
Even if the diversified investor loses overall, chances are his losses will be smaller than the losses of the non-diversified investor.
Experienced investors know that no matter how good their analysis is, there are always black swan events (things that cannot be predicted, such as the rise of COVID) that can easily destroy even the most conservative calculations and predictions made during your due diligence. That’s why even if you truly believe in an industry or particular stock with all your heart, it’s still wise to diversify—just in case.
WHY YOU SHOULD DIVERSIFY?
As discussed already, diversification is a risk-mitigating strategy. The returns are generally lower than betting heavy on one (or only a few) particular investments, but the returns are generally safer and more consistent. Especially when you are a beginner investor who doesn’t know how to properly analyze everything, diversification alleviates the pressure of needing to be “right” because your mistakes will be balanced out by the wins (even if they are accidental or unexpected wins).
Some people like to have two classes of money: risk capital and investment capital.
Risk capital is basically funds for gambling, because that’s how you should see it. You’re gambling (not strategically investing) in a particular investment, hoping it has a moon shot and you make a tidy fortune. But if you lose it all, oh well, because you knew the risks ahead of time and can stomach that loss.
Investment capital is safer capital. Nothing is guaranteed, and there is always the risk of 100% loss (even though it’s a small risk), but by diversifying with your investment capital, you can relatively confidently expect positive returns at least over a period of several years. Maybe one or two years will be in the red (negative), but more than likely, the other years will push you into the positive.
WAYS TO DIVERSIFY (target retirement funds, which brokerages, manually balancing and rebalancing)
Since there are virtually unlimited ways you can split up your investment funds, that means there are unlimited ways you can diversify. This sheer amount of selection can be overwhelming and paralyzing that you end up not making a decision at all.
Luckily, if you don’t want to manually choose your investment assets, industries, or stocks, there are easy ways to still diversify without much brain work. It alleviates the pressure of needing to do significant research.
In many stock brokerages like Vanguard, you can invest in retirement funds (also known as target date funds) or in index funds. Both of these are great ways to easily diversify.
Retirement funds are a mix (diversified) selection of investments between stocks and bonds that the brokerage manages for you. They pick the exact stocks and allocation for you and adjust it over time based on assumed risk appetites. In general, younger people are willing to take on more risk in hopes of higher returns because if things go sour, they still have several decades of investing to make up for their losses. But as they age, they become more risk-averse because the goal is no longer to grow your money but to preserve (i.e. not loss) your money. If you’re nearing retirement age, around 65 years old, one market downturn can mean losing the chance to live a comfortable retirement and instead force you to live off half (or less) of the money you expected. Not a pleasant surprise in your final years, which should be your golden years. After a lifetime of working, this certainly isn’t the dream, which is why older investors want to slowly ramp down their risk, even though it means accepting lower returns over time.
A retirement fund automatically makes these adjustments for you, so you don’t have to actively research and change your stocks and investments. All the heavy lifting is adjusted for you. So if you want the most hands-off way of investing that is diversified, retirement funds are the best way to go.
Then there is also the option of index funds. An index is basically a tracker of how well a particular group of companies are doing. For example, the S&P500 index fund includes America’s top 500 companies all together. By buying 1 share of this index, you are investing in all 500 of these companies. If some of them do well, others do poorly, you get natural diversification. If you look at the history of the stock market, the S&P500 has averaged 11.88% per year since its inception through the end of 2021. Obviously, some years were downright bad, but other years were surprisingly good, so it all averages out.
It’s nearly impossible to beat the S&P500’s performance over any extended period of time. You may be able to outperform the S&P500 by manually picking your stocks for a few years…but to do so for 10, 20, 30 years? Less than 0.1% chance!
You can easily diversify by investing in index funds through a wide selection of brokerages, such as Vanguard, TD Ameritrade, Charles Schwab, Robinhood, Webull, MooMoo, and so many more.
And there are tons of different index funds available, all indexing different things. The S&P500 indexes America’s top 500 companies, but other index funds may diversify into the top technology stocks or the top banking stocks or foreign country stocks. It’s up to you to decide how you want to diversify, but index funds makes it easy to get wide exposure into multiple companies at once, instead of having to buy each one manually.
Since you don’t have to buy each stock manually, it also requires far less capital upfront to gain exposure to multiple companies. Sometimes, it may not be possible to buy a fractional share of a company, so the minimum amount invested in that one company might be 1 share. If that 1 share costs $1,000 and you intend to invest in 100 similar companies that also have a minimum $1,000/share, then that’s at least $100,000 to gain diversification across these 100 companies.
What if you don’t have $100k? Then you cannot spread your diversification as wide as you’d like if you were buying individual company stocks. But with index funds, each index fund share is probably much lower, maybe $200/share. And you’d get a fractional exposure to each of those 100 companies being indexed. So you only need $20,000, which is far easier to amass than $100k. That’s one of the key advantages of index fund investing—lower starting capital needed, plus ease of management and purchasing.
REBALANCING PORTFOLIOS TO STAY DIVERSIFIED
One often overlooked concept when it comes to diversification is rebalancing. When you purchase your initial investments, you may be well diversified, but this diversification level will shift over time as specific companies gain or lose share value. In time, you may become heavily UN-diversified even if you didn’t make any changes yourself.
How? Well, let’s take a look at a hypothetical example. What if you had $10,000 to start, which you evenly split between 10 different companies ($1,000 each).
Let’s say Companies A and B do extremely well as quadruple in value over 3 years. Now the $2,000 you invested in those combined is worth $8,000 combined.
But then let’s say Companies B, C, D, E, and F just do okay. The original $5,000 there only turns into $7,000 after 3 years.
Then Companies G, H, and J lost money, so the original $3,000 is only worth $1,000 after 3 years.
Overall, you have made a huge profit:
+$6,000
+$2,000
-$2,000
========
Profit: $6,000 on your initial $10,000, which is a 60% return (amazing!).
However, let’s see how your portfolio is weighted in each of the 10 companies now.
When you started, each company was worth exactly 10% of your portfolio, so it was well diversified.
But now after 3 years, Companies A and B are worth $8,000 out of your total $16,000. That’s 50% of your portfolio wrapped up in only two companies! Before, those two companies were only worth 20% together, but now they are worth 50% of your portfolio. Are you seeing how unbalanced things are getting? What if those companies now have a really terrible year? You would be DISPROPORTIONALLY affected towards the negative!
As for the 3 losing companies? They were worth 30% of your portfolio to start. But after 3 years, they only account for $1,000 out of your total $16,000 (a mere 6.25%, waaaay down from 30%). So even if these 3 companies suddenly have a spectacular year, you wouldn’t make much money from them.
That’s why it’s important to REBALANCE your portfolio every now and then, typically every 6 months to 1 year.
When you see certain companies taking up too large a percentage in your portfolio, you may want to sell some shares in the winners to lock in your profits but also bring their overweighted percentage back down to more balanced percentages. As for the losing companies, if you still believe in them in the long-run, then consider purchasing more shares of them (which will be at a “discount” compared to your original purchase price) to bring the overall percentage for those companies more in line with the other companies in your portfolio.
This management process is quite burdensome and requires some tedious math though, which is why many investors can’t be bothered to do it. That risks losing the benefits of diversification in the first place.
Hence, I recommend using auto-rebalancing investment methods, such as retirement funds. These funds automatically rebalance and adjust for you! It’s honestly the most hands-free way of investing wisely with minimal fees and relatively high promise of return. No wonder they’re so popular!
CONCLUSION
So there you have it! Diversification is arguably the most important concept to understand for any successful investor. Don’t put all your eggs in one basket because that’s pure gambling. Take a more measured, less risky approach. You can make respectable gains over the long run if you aren’t greedy and simply stay the course like the tortoise in that fabled race. However you want to diversify is you to you with varying levels of risk, but just remember to diversify to some level! Good luck!
