Understanding Diversification

Pie Chart

Having a diversified portfolio is one of the keys to successfully managing your wealth. But while the idea of diversification may seem simple—putting all your eggs in one basket generally isn’t a good idea—it’s often misunderstood.

Simply having a lot of different investments doesn’t necessarily mean you have a diversified portfolio. Having a large number of stocks that are all in the same sector of the market—a lot of technology stocks, for example—doesn’t offer much diversification: if something happens to that sector, all of the stocks could decline at the same time.

Even having a large number of funds (which offer more diversification than individual stocks or bonds) doesn’t guarantee you’ll have a well-diversified portfolio. If all the funds have similar characteristics, they’re likely to all rise and fall at the same time. In other words, even if your eggs are in different baskets, it won’t do you much good if the baskets are all tied together.

So if the raw number of different investments doesn’t matter, what does? The goal of diversification is to lower the overall risk of a portfolio by putting together different investments that don’t all go up or down at the same time. A well-diversified portfolio will therefore have a mix of different asset classes, different stock sectors, different bond sectors, and different regions of the world. A portfolio that’s too concentrated along any one of these dimensions is not well-diversified, no matter how many individual investments in contains.

Topics: Blog Risk Diversification