Diversification How Important Is it for You

Diversification

How important is it for you to diversify your investment portfolio? How would you diversify your investment portfolio?

Although 'the stock market' is often spoken of as a collective entity, in reality it is made up of a many different types of industry subsets. Furthermore, stocks are not the only assets investors should have: bonds, CDs, and more conservative and risky investments make up the full 'buffet' of available ways to allocate funds. The right 'menu' of investments will vary depending upon the investor's age, comfort with risk, goals, and other factors. "To build a diversified portfolio, an investor should look for assets whose returns haven't historically moved in the same direction, and, ideally, assets whose returns move in the opposite direction. This way, even if a portion of your portfolio is declining, the rest of your portfolio is designed to be growing. Thus, you can potentially offset the impact of poor market performance on your overall portfolio" (The pro's guide to diversification, 2013, Fidelity Investments).

Both types of investments (stocks vs. bonds) and also the specific investments themselves (different types of stocks) should be diversified according to most investment analysts. From a mathematical perspective, "your ability to reduce firm-specific risk in a portfolio depends on the relative correlation of the assets held in the portfolio. Correlation describes the degree to which returns on investments move together… An important principle in finance is that risk reduction cannot be achieved through diversification if the returns on two or more assets are perfectly positively correlated" (Risk and return: Diversification, 2013, PreMBA test). In other words, if an investor has stock in Nike, it would make sense to have other types of investments in his or her portfolio that 'trended' in different directions, versus correlating with the performance of consumer goods like apparel and sports equipment. If contemplating buying Tiffany stock, for example, the question would be if the stock's performance was correlated with or against Nike. Although both are in different industries, because they are somewhat pricey and are not strictly 'necessities' this might not be the case. A variety of statistical evidence supports the correlation of diversification and slowly building wealth but stresses the need for diversification to be meaningful and involve more than one or two stocks. "As many studies have shown, at least 40% of the variability in returns can be reduced by moving from a single company to 20. Once a portfolio contains 20 or 30 stocks, adding more does little to damp the fluctuations in wealth over time" (Slome 2009).