If there is one thing in the world of the stock market that every investor should be well aware of, then it’s “diversification.” It is not just another rule of investment; it matters more than you think. In simple terms, diversification means not putting all your money in a single place, but spreading it across multiple asset classes.
But what makes “diversification” so important for investors? Because the investment market is full of surprises, and you won’t want to lose your money when one company or one industry (where you have invested major portion your hard-earned money/savings) faces a loss. Diversification in investment is a powerful way to build a strong financial safety net.
What is Investment Diversification?
In simple words, diversification in the stock market means spreading your money across multiple asset classes, sectors, and even geographies. That means instead of buying shares of just one or two companies, you buy shares of multiple companies. You also buy different types of assets like stocks, mutual funds, ETFs, and bonds.
When you diversify your portfolio, the failure of one investment won’t ruin your entire portfolio, as the poor performance of one investment will be balanced by the better performance of another. The main goal of diversification is not to earn higher returns. The goal is to lower your overall risk and achieve steady, substantial growth over the years.
What Happens When You Invest Only In One (Or A Few) Stocks
When you are putting most of your money into a single (or just a few) stocks, you are taking a huge risk. Because the returns are highly dependent on the performance of those few stocks. While this approach might feel exciting when that stock goes up, it would feel terrifying when it goes down.
Let’s understand this with an example. Suppose you have invested 80-90% of your savings into a high-profile tech company because you believe it is going to work well in the market, or you expect it to. And for a while, the company does great, but then, to your surprise, one unexpected event occurs and the company’s stock price immediately drops by 50-60%. And now, as almost all of your money was invested in the same company, your entire portfolio will face a massive and sudden loss.
The diversification strategy is specifically aimed at protecting you from this kind of sudden loss, which is tied to one specific company stock.
Diversifying Across Different Industries/Sectors
One of the simplest ways to diversify your portfolio is to invest your money across different companies operating in different sectors. This strategy will ensure that a single economic event does not impact all of your investments.
For example, investing in the technology sector tends to grow fast or perform well when the economy is growing fast. However, during recession periods, investing in the technology sector might not perform well, but people will still need healthcare or medicines. Therefore, having a healthcare stock simultaneously with a technology sector stock will keep your portfolio stable, and it will continue to grow.
In other words, we can say that by owning stocks in both the technology and healthcare sectors, you will create a balance. If the tech sector has a downtime, the stable returns from the healthcare sector will help you to offset the losses. This strategy prevents your overall portfolio from experiencing full losses due to one sector’s downfall.
Diversifying Across Different Asset Classes
Smart investors are those who not only invest in different types of stocks but also invest their money in different types of asset classes. To diversify your portfolio across asset classes simply means you are spreading your investment money among various types of assets, such as stocks, bonds, real estate, and commodities. The two main types you need to know about are stocks and bonds.
Stocks: “Stocks” or “equities” mean having a partial ownership in a company. Companies issue stock to raise funds for their growth or expansion. While investors profit through dividends and capital appreciation.
Bonds: Bonds are debt instruments. It is essentially a loan you give to a Government or a company. By investing in bonds, you earn returns in the form of interest payments and principal repayment at maturity.
Stocks are considered riskier than bonds, as the stock value fluctuates depending on the performance of the company. Bonds are usually more stable, as they change value not as quickly as stocks.
How Do You Benefit From The Balance Of Both: Stocks and Bonds
Diversifying your portfolio in stocks and bonds provides you with both the high growth potential from stocks and the stability and regular income from bonds. This also prevents your overall portfolio from crashing down. For example, when the stock is going down, your bond gives you potential steady growth.
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Geographic Diversification
Invest your money globally because the economic conditions of each country differ. Limiting investments only to your domestic country will expose you to the specific economic and political risks of your nation. On the other hand, by investing your money in a mix of national and international markets, you will enhance your chances or opportunities for potential gain.
For example, suppose you have invested only in the Indian economy, and due to political reasons or high inflation, the country goes through a terrible year financially. And if you have a major part of your investments in the Indian economy, then you are in trouble, as there are high chances of you losing money in the market. But if you have invested 30-40% of your money in the foreign market, and those markets are thriving, the gains from these markets will help you reduce your losses in the Indian market.
Why Diversification in the Stock Market Matters?
Diversification is crucial because it protects your money from sudden market shocks.
- It’s not easy to predict any single company’s future performance. Diversification ensures that the poor performance of that single company does not become the reason for your financial loss.
- By owning investments in both shares and bonds, you reduce volatility, as you will reduce the chances of a drop in your overall portfolio. When the stock market goes down, bonds may still give you steady returns.
- Having a diversified portfolio also prevents you from making costly mistakes. Seeing all your money drop can be fearful, and you might panic & sell everything at the wrong time. But diversification helps you smooth out those falls, making it easier for you to stay calm, hold onto your investments for longer, and benefit from the market’s recovery.
Learn More About Diversification at Strategic Alpha
Diversification in the stock market is a crucial part of your investment strategy. So, diversify and make your portfolio safer. If you need help or want to learn more about the diversification strategy, you must explore the various learning resources available at Strategic Alpha. You can also take part in weekly webinars, read in-depth guides, or connect with our mentor expert who can guide you in balancing your holdings. You can also join the conviction club to get access to premium learning modules and also have one-on-one conversations with investment experts like Suyog Dhavan.
