What Is Diversification?

Most people have heard the expression: don’t put all your eggs in one basket.

The idea is simple. If everything you have depends on one basket and something happens to it, you have a problem.

In investing, the same principle is known as diversification.

Diversification means spreading your investments so that you are not relying too heavily on one company, one industry, one part of the world or one type of investment.

The phrase about eggs and baskets is useful. The investment idea behind it is worth understanding properly.

Diversification Means Spreading Your Investments

Imagine you invested all your money in the shares of one company.

If that company performed well, you could benefit considerably.

If it ran into serious difficulties, you could also lose a significant amount of money.

Your financial outcome would depend heavily on what happened to that one business. You can read more about what owning shares actually means in What Is a Share?

Now imagine that instead of relying on one company, your money was spread across hundreds or even thousands of different companies.

One company performing badly would still affect you, but it would usually have a much smaller impact on your overall investments.

That is diversification in its simplest form.

Rather than relying on one investment working out as hoped, you spread your money across many.

Owning Lots of Investments Isn’t Necessarily Enough

Diversification is not simply about owning as many investments as possible.

You could own shares in 20 different companies and still be relying heavily on one part of the market if they were all similar businesses.

For example, imagine they were all technology companies. Something that affected the technology industry could affect many of them at the same time.

This is why diversification can take place at several different levels.

You can spread your money across different companies and industries, such as technology, healthcare, manufacturing and financial services.

You can invest across different countries and regions rather than relying heavily on what happens in one part of the world.

You can also spread money across different types of investments, known as asset classes. These might include shares in companies and bonds, which are essentially loans to governments or companies. You can read more about how bonds work in What Is a Government Bond? and What Is a Corporate Bond?

How much you hold in each type of investment is known as asset allocation. I explore this in What Is Asset Allocation?

Different asset classes can respond differently to changing economic and market conditions.

That doesn't mean one will always rise when another falls. There will be periods when different asset classes fall at the same time.

The aim is not to find investments that perfectly cancel each other out. It is to avoid relying too heavily on one company, industry, country or type of investment.

Why Does Diversification Matter?

If we knew with certainty which investment would produce the best return over the next 20 years, diversification would seem unnecessary.

We could simply put all our money into that investment.

The difficulty, of course, is that we don’t know.

• We don’t know which companies will become the most successful.
• We don’t know which industries will grow fastest.
• We don’t know which countries will produce the strongest investment returns.

There will always be opinions about what might happen next. Investors can research companies, economies and markets in enormous detail and that information can be useful.

It cannot remove uncertainty.

This is why there is more to diversification than simply spreading your money around.

Diversification is an acknowledgement that we might be wrong.

Rather than building an investment portfolio that depends on our ability to predict the future correctly, diversification accepts that some of our expectations will inevitably turn out differently from what we imagined.

There Is Also a Risk in What You Don’t Own

When we think about investment risk, it is natural to focus on the investments we own.

• What if a company fails?
• What if a particular industry struggles?
• What if one country’s stock market performs badly for a long period?

Diversification can reduce how heavily your investments depend on any one of those outcomes.

There is another side to this though.

There is also a risk in what you don’t own.

Imagine concentrating your investments in a handful of companies you believe have the best prospects. You might successfully avoid many businesses that go on to perform poorly.

You might also miss companies that become enormously successful.

The same applies to industries and countries.

Diversification doesn't mean you will own every successful investment. It means your financial outcome is less dependent on correctly identifying a small number of winners in advance.

Diversification Can Feel Disappointing

Diversification involves a trade-off.

If one investment produces spectacular returns, you would have achieved a higher return, with hindsight, by having all your money invested there.

The problem is that hindsight wasn't available when you made the decision.

At almost any point, some parts of a diversified portfolio will be performing better than others.

One part of the world might be producing strong returns while another is struggling. One industry might be attracting enormous attention while another appears dull. Shares might be performing well while bonds are disappointing.

Looking backwards, the perfect portfolio is easy to construct.

You simply remove everything that disappointed and put more money into whatever performed best.

The difficulty is that you didn't know which investments those would be beforehand.

This can make diversification look unnecessary when one particular company, industry or market has been doing exceptionally well.

Yet the future remains uncertain, even when the recent past looks obvious.

Diversification Does Not Remove Investment Risk

Diversification has limits.

Spreading your investments can reduce the impact of being too heavily exposed to one company, industry, country or type of investment.

It cannot prevent your investments from falling in value or you even getting back less than you invested.

Nor does diversification mean that when one investment falls another will always rise.

During periods of market stress, different companies, markets and even different asset classes can fall at the same time. A diversified portfolio can still experience significant losses.

Diversification cannot guarantee a particular return either.

The value of investments can fall as well as rise and you could get back less than you invest.

Diversification is therefore not about removing investment risk.

It is about reducing how much your financial outcome depends on one particular investment or part of the market.

How Investment Funds Can Help

One practical way of diversifying is through investment funds. You can read more about how they work in What Is an Investment Fund?

An investment fund brings together money from lots of investors and invests it according to a particular strategy.

Depending on the fund, that might provide exposure to hundreds or even thousands of different investments.

This can make it much easier to spread your money than trying to buy large numbers of individual investments yourself.

It is worth remembering that owning a fund does not automatically mean you are well diversified.

Some funds invest very broadly across different companies and countries. Others deliberately focus on a particular industry, region or type of company.

You can also own several different funds that hold many of the same underlying investments.

This means one broadly invested fund could provide greater diversification than several narrowly focused funds.

The number of funds you own therefore tells you relatively little on its own. What matters is what you actually own through them and how those investments fit together.

Diversification Is About Accepting Uncertainty

Diversification is not based on knowing what will happen next.

It is a response to the fact that we don’t.

Some of the investments you own will perform better than others. Looking backwards, there will always be something you wish you had owned more of.

Diversification accepts that uncertainty rather than pretending we can remove it.

Its purpose isn’t to make sure we are always right.

It is to make being wrong about one investment less damaging.

This article is for general information only and should not be treated as personal financial advice. The appropriate mix of investments will depend on your individual circumstances, objectives and attitude to investment risk.

Matthew Birkett
Chartered Financial Planner
Birkett Financial Planning