The Motley Fool

Guide To Diversification: What It Is And Why You Need It

Diversification is a word that you often come across in relation to investing. Here we look at the meaning of diversification, why and how it works, and how you can apply it to your investment portfolio.

What is diversification? 

Diversification is the process of choosing a number of different types of investments to lower your overall risk. 

For example, some investments are exposed to particular parts of the economy while others are more sensitive to higher-level economic matters like interest rates or the overall rate of growth in the economy.

Let’s take an extreme example. Say you were invested in a number of different companies but they all made petrol-powered cars. Then the government comes along and says, from tomorrow, only electric cars can be sold. In one stroke, all your companies are crushed and they might go out of business entirely. That is certainly not diversification!

However, if you are invested in a number of different industries — such as retail, finance, technology, healthcare, and so on — then your portfolio should be well diversified and therefore be a lot more robust. You shouldn’t be as exposed to a few economic or policy changes damaging your investment portfolio to a large extent.

In practice, diversification has a wider meaning as it extends a lot further than buying companies in different industry sectors: 

You might want to limit the number of investments you have that are reliant on a small number of customers or suppliers. 

You can diversify across different countries or regions of the world. 

You can diversify between small companies and large companies. 

You can diversify across cyclical stocks (those most exposed to the rate of growth in the economy, such as banks) or defensive stocks (those where demand doesn’t change that much over the economic cycle, such as supermarkets).

You can also diversify across different asset classes such as stocks and shares, bonds, property, commodities, and so on.

To summarise by using a popular phrase, the short answer to “what is diversification?” is don’t put all your eggs in one basket!

Why is diversification important in investing?

When you own a well-diversified portfolio, its overall value should be a lot less volatile over time. Anything that changes significantly in price from day to day can be tough to hold onto. It takes its toll on you mentally, especially when your portfolio grows in size.

Another thing to appreciate is that certain types of investment drift in and out of fashion all the time. So whole industries can fall out of favour for months or even a few years and that might affect the price of every single company in that sector, regardless of how well they are doing individually. 

This works in reverse as well. When investors fall in love with a particular technology or industry, just about every single company involved with it might see its share price rise, regardless of how strong and durable their underlying business is.

It’s also important to realise that predicting what any single investment will do over the long term is next to impossible. Betting on a single industry or technology could, in theory, make you extremely rich if you guess right and get in early, but it involves an enormous amount of luck. It’s better to go for some diversification, making a wider range of investments to increase your overall chance of doing well.

How to diversify your investment portfolio

The simplest way to achieve diversification with your investment portfolio, especially if you are just getting started in investing, is to buy an index fund that tracks global stock markets. That way you can buy a stake in thousands of companies, spread across different sectors and countries at a very low cost.

Alternatively, you could take more of a DIY approach and buy several index funds in the types of investments that you think look the most attractive, such as technology, smaller companies, or Asian stocks.

If you want to choose a diversified portfolio of individual stocks then a little more thought is required. You could consider what is driving the growth of each business and what the major risks they face are. This can be done at a high level or in a large amount of detail, depending on how much depth you want to go into and how experienced you are as an investor.

How many stocks you need in a diversified portfolio is a matter of some debate. Some people reckon that as few as 10 to 12 well-chosen shares can give you a pretty high level of diversification. Others reckon that a few dozen to as much as a hundred is more appropriate. We’d suggest starting towards the lower end, especially when you are just learning to invest as you can always add additional investments over time.

Diversifying across different types of asset is also important. As a very rough guide, the longer your investment horizon, the more you want to be exposed to potentially higher-growth assets like stocks and shares. Likewise, if you prefer a portfolio that will give a smoother ride, you might have less exposure to the stock market and more to fixed income (i.e. company and government bonds).

Here are some numbers from Vanguard, one of the largest investment firms in the world, showing how portfolios with various mixes of shares and fixed income have moved in the past. These numbers are based on the US markets, but the same principles apply here in the UK and they show us how diversification can impact both overall returns and the extent of any downside you will need to cope with.

Portfolio Mix

Average Annual Return

Best
Year

Worst

 Year

Years with negative returns

100% bonds

6.1%

46%

-8%

19 out of 95

80% bonds and 20% shares

7.2%

41%

-10%

16 out of 95

60% bonds and 40% shares

8.2%

36%

-18%

19 out of 95

40% bonds and 60% shares

9.1%

37%

-27%

22 out of 95

20% bonds and 80% shares

9.8%

45%

-35%

24 out of 95

100% stocks

10.3%

54%

-43%

25 out of 95

Source: Vanguard, based on US market data from 1926 to 2020

We don’t know for sure what will happen in the future but looking at past returns can give us a guide as to what to expect. Here we can see that the average return increases the more shares and the less bonds you have. However, the potential losses become more frequent and increase significantly in size.

Finally, the acid test of whether you have achieved an appropriate level of diversification is something you only discover once you are invested. Do you have a portfolio that you can comfortably hold onto when times get tough and the markets hit a rocky patch?

Another good thing to look for is how the individual prices in your portfolio move over time. If you find that everything goes up or down by roughly the same proportion at the same time, then that’s a pretty good sign that you may not be that well diversified after all!

Looking for more investment ideas?

Identifying the best investment opportunities requires long hours of in-depth research. But having a true ‘edge’ can make all the difference to your portfolio’s returns, especially during a bear market like this one.

That’s why, when it comes to helping to select their next investment, thousands of UK investors turn to Motley Fool Share Advisor. Led by a world-class team of expert investors, The Motley Fool UK’s flagship share-tipping newsletter alerts its members to 2 high-potential, high-conviction UK and US stock recommendations each and every month.

These are the sort of investment opportunities that could help contribute to life-changing scenarios. And right now, you can access ALL of them for just pennies a day.

So if you’re eager to start aiming for better investment returns, then don’t wait another minute… Start your Motley Fool Share Advisor membership — backed by our iron clad 30-Day Subscription Refund Guarantee — TODAY.