The Importance of Diversification
An often overlooked method of ensuring maximum returns on your portfolio
Look at the lineup of your favorite baseball team. You’ll notice a variety of players from top to bottom.
There’s the speedy leadoff hitter who can steal bases; the big, powerful home run hitter, the good contact batter who hits for high average; perhaps a weak-hitting but good defensive shortstop.
You won’t find nine home run hitters or nine speedy base stealers or nine of any single type of player. Good managers know they need to diversify their lineups to win ball games.
As the manager of your portfolio, you too need to understand the importance of diversification. Just as there will be days when the wind is blowing in, and those home run hitters are making outs, there will be periods when some of your holdings will lose money. When that occurs, you need other investments to offset the decline.
Diversification is important to all investors. It’s something that socially responsible investors in particular need to notice because their universe of investment options is smaller than that of traditional investors. When creating an SRI portfolio, it’s important to be sure that the elements within it not only meet your social or environmental concerns but that they don’t create an unwanted risk to your capital by being slanted one way or another.
One form of diversification is asset allocation. By having elements of different investment classes in your portfolio - including stocks, bonds, cash, real estate, gold or other commodities - you can protect your portfolio from losing the value that it might if it only contained one failing asset category.
When stock prices fall, for example, bond prices often rise because investors move their money into what is considered a less risky investment. So a portfolio that included stocks and bonds would perform differently than one that included only stocks at the time of a stock market drop.
It’s also wise to diversify within asset classes. Investors who loaded up on tech stocks in 2000 lost their shirts when the dot.com bubble burst, and technology shares rapidly fell out of favor. Similarly, financial stocks were hammered down in late 2007 and early 2008 due to the subprime mortgage crisis.
And if it seems risky to put all or most of your money into a single sector, it would be even more so to do the same on a single stock. That's what many investors did in the late 1990s, often as employees of tech companies who allowed their holdings to become top-heavy in their employer’s stock. These essentially one-stock portfolios were akin to flagpole sitters in the 1930s – perched high in the air with only a long, narrow pole for support. In December of 2000 shares of Amazon were selling for more than $100.
By the following September, they had fallen to below $6. It wasn’t until December of 2007 that it had climbed back into the $90s.
So the two steps to diversification are to spread your money among different asset categories, then further allocate those funds within each category. A smart approach for individual investors is to diversify using mutual funds. Because mutual funds are groups of stocks, you’ll be diversified to a certain degree by definition.
But you should go one step further by buying different types of funds. Many advisors recommend beginning with a broad-based index fund that merely tries to mirror the performance of the S&P 500. Then you could complement that index fund with a fund that purchases shares in overseas companies; one that consists of shares of small growth companies; one that invests in bonds and another that buys shares in real estate investment trusts (REITs).
At websites such as Morningstar, SmartMoney, and the street.com, you can find analysis and information about mutual funds to get you started. Remember to notice fees and expenses when comparing funds.
Remember, good baseball teams score runs and win games in many ways. By diversifying your portfolio, you’ll give yourself an opportunity to grow your money despite the ups and downs that come with investing.