I’m sure you’ve all heard the saying, “don’t put all your eggs in one basket!” Whether it’s coming from your grandmother after she heard your teenage dream of being in a rock band or from a financial advisor (I would definitely listen to your rock band), it’s true. Putting all your eggs in one basket is a sure-fire way to piss off the Easter Bunny - and your investment portfolio. Equity Diversification is Easter Bunny approved, so let’s take a look at why.
The Sunny Side of Diversification
Equity Diversification is the act of investing in multiple areas that would likely act differently during a market event. By buying stocks in these different categories, you reduce the risk that if the value drops in one area, the value will rise in another. For example, let's say you buy stock in airlines. That might seem like a great idea with a beautiful summer coming up, right? Well, imagine a pandemic tears through the globe, and international travel ceases for two weeks (which is code for one year); what then? Well, if all of your eggs were in something similar to the airline basket, then the Easter Bunny would already be knocking at your door. If your eggs were allocated strategically between stocks in airlines and stocks in automotive transportation, such as RV’s, your investment portfolio might be sunny-side up after all.
The Risks of Being Related
No, we are not talking about the sibling you're embarrassed by. The risk of being related is the risk of having your stocks relate too much to each other to reap any real benefits of diversification. The example I gave of airline stock vs. RV stock is not incorrect. By buying stocks in the different modes of transportation, you can help counterbalance the loss of one transportation method becoming unavailable by reaping the benefits of another transportation method taking its place. We will never not need to get somewhere, so having stocks in different ways of doing that is likely a good idea and a good example of diversifying your portfolio. But these benefits only become more significant, and the safety net only becomes stronger when your stock collection becomes even weirder. The more diverse and different your investments are from one another, the more likely you are to avoid loss in many of the areas you have invested in. The key is that the stocks should be so different from each other; a move in the market might impact some categories but leave others completely untouched.
Investing in airlines and RV’s is great, but what about also investing in something totally outside transportation - like, ice cream? Let’s say you buy a stock in an ice cream company, and when the world shuts down, and quarantine begins, the loss you might feel from families unable to transport anywhere at any time will be confined to those two areas of your portfolio. The ice cream stock is safe, stable, and untouched.
Different Assets, Different Actions
So, buying stocks in diversified companies and categories is a little bit like an insurance policy. But I said the weirder, the better. Airlines and ice cream are a pretty odd combo, so they’d look great together in your portfolio, sure. But the differences can go even further. Diversifying your assets in terms of stocks vs. bonds is another excellent way to split your eggs, specifically because stock eggs and bond eggs typically act adversely during market events. When the market swings, bonds will rise while stocks typically fall and vice versa, depending on the scenario. Naturally, bonds and stocks move in opposite directions, so keeping a collection of them both will help ensure that you stay balanced in the middle.
Your Money Doesn’t Need To Live Where You Do
Many people make the mistake of moving their money in with them, confining it to one location (their location), and refusing to send it out to different parts of the world. By owning stocks in your area only, you are susceptible to loss when an event occurs that impacts your location. When you choose to keep your money in stocks tied to different areas, you can be sure that even when the market moves down in the place you live, the market may be stable elsewhere. For example, if the market falls in the United States, stocks you own overseas might be smiling and waving from across the water.
All Together
Your investments are safer when they are spread out across multiple companies, categories, and asset types. The more different your money is, the more durable it will be. Diversifying helps it become less susceptible to market shifts and more likely to balance or counteract financial falls. All together, diversification is highly beneficial when it comes to risk management and is often encouraged by financial advisors and bunnies alike.
Sources:
https://www.investopedia.com/investing/importance-diversification/
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