Investment Diversification is Important. Here’s Why.
Diversification is an important part of investing and has been described as the only “free lunch” in the investment world. Why is diversification so important? Read this article to learn more.
What Is Diversification?
Diversification of investments is a strategy that is used to lower the overall risk exposure of an investment portfolio. It most often involves investing in several asset classes, whereby the losses of one asset class may be offset by the gains of the other asset classes.
Diversification across asset classes may include owning stocks from a number of different industries, countries and risk profiles, as well as other asset classes such as bonds, commodities, real estate and an ever-increasing variety of alternative investments.
Furthermore, diversification of securities within an asset class is as important as diversification across asset classes.
“Diversification is an established tenet of conservative investment.” – Benjamin Graham
Benefits of Diversification
The empirical benefits of diversification were first presented by economist Harry Markowitz in his 1952 publication “Portfolio Selection.”
Markowitz proposed that it is possible for investors to construct a portfolio that would optimize potential returns relative to a quantifiable risk level.
In other words, portfolio risk can be reduced by applying a methodology which Markowitz termed “Modern Portfolio Theory (MPT).” MPT demonstrates that portfolio diversification can reduce investment risk. (We will cover Modern Portfolio Theory more thoroughly in a future article.) For their life’s work on investment and risk, Harry Markowitz, Merton H. Miller and William F. Sharpe shared the 1990 Nobel Prize in Economic Sciences.
Benefits of diversification include:
- Minimizing risk of loss—while one or more investments or asset classes may underperform over a period of time, other investments or asset classes may outperform over the same period.
- Preserving capital—not all investors are in the accumulation phase but may be closer to retirement and prefer capital preservation strategies for which diversification is an excellent option.
- Diverging returns—an investment or asset class may not perform as expected, but by diversifying, you are not dependent on one source of investment returns.
Potential Drawbacks of Diversification
While widely accepted among investors that some amount of diversification is vital to reduce the risks of volatility, losing money and emotional stress, there are some potential disadvantages to diversification.
- Limits potential gains—while diversification limits downside risk, this comes at the cost of potentially limiting some upside returns.
- Over-diversification—investing in too many securities will cause the portfolio to mimic the market as with closet-indexing but at a higher cost.
- Naïve diversification—building a portfolio without understanding each investment’s risk and its influence on total portfolio risk can result in a higher risk portfolio.
Warren Buffett, widely recognized as a non-supporter of broad diversification, at least acknowledged it had some purpose in saying:
“Diversification may preserve wealth but concentration builds wealth.” – especially as he became a victim of his own success, and as his assets grew so did his portfolio diversification—intentional or not.
To diversify, or not to diversify? That is the question—and the answer will always be to diversify but at a level that is right for you.
The Bottom Line
When a portfolio is well-diversified and not concentrated around a few particular investments and sectors, the individual risk of each stock will have less of an impact on the overall portfolio risk, enabling you to protect, preserve and build wealth; however, diversification only works properly if you understand how to apply it.
There is no magic formula that can calculate how diversified your portfolio should be. Rather, the key is to determine the right level of diversification needed to meet your unique investment needs, objectives and risk tolerance.
Start Diversifying Today
One of the simplest (and least risky) methods of creating a diversified investment portfolio that protects, preserves and builds your wealth is to let an experienced professional investment manager do the work.
At Bloom Investment Counsel, Inc. we have more than 37 years of experience building optimally diversified income-paying equity portfolios for wealthy individuals, family offices, foundations, corporations, institutions and trusts that are specific to each client’s financial circumstances and investment goals. The question of the right level of diversification to meet your unique investment needs, objectives and risk tolerance can be answered when you connect with experienced portfolio managers who are committed to fulfilling their clients’ long-term financial needs, objectives and/or legacy goals rather than chasing market highs. Visit Bloom’s website to learn more about our investment approach or get in touch today.
This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.