Importance of diversification

Diversification is the process of spreading investments across different asset classes, industries, and geographic regions to reduce the overall risk of an investment portfolio. The idea is that by holding a variety of investments, the poor performance of any one investment potentially can be offset by the better performance of another, leading to a more consistent overall return. Diversification thus aims to include assets that are not highly correlated with one another.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial

goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

Let’s say you have an investment portfolio that only contains airline stocks. Share prices of all those stocks potentially will drop in tandem after industry-specific bad news, such as an indefinite pilots strike that will ultimately cancel flights. This means your portfolio will experience a noticeable drop in value. You can counterbalance these stocks with a few railway stocks, so only part of your portfolio will be affected. In fact, there is a very good chance that the railroad stock prices will rise, as passengers look for alternative modes of transportation.

This action of proactively balancing your portfolio across different investments is at the heart of diversification. Instead of attempting to maximize your returns by investing in the most profitable companies, you enact a defensive position when diversifying. The strategy of diversification is actively promoted by the U.S. Securities and Exchange Commission.

The example above of buying railroad stocks to protect against detrimental changes to the airline industry is diversifying within a sector or industry. In this case, an investor is interested in investing in the transportation sector and holds multiple positions within one industry.

You could diversify even further because of the risks associated with these companies. That’s because anything that affects travel in general will hurt both industries. This means you should consider diversifying outside the industry. For example, if consumers are less likely to travel, they may be more likely to stay home and consume streaming services (thereby boosting technology or media companies).

Risk doesn’t necessarily have to be specific to an industry—it’s often present at a company-specific level. Imagine a company with a revolutionary leader. Should that leader leave the company or pass away, the company will be negatively affected. Risk specific to a company can occur from legislation, acts of nature, or consumer preference. As such, you might have your favorite airline that you personally choose to fly with, but if you’re a strong believer in the future of air travel, consider diversifying by acquiring shares of a different airline provider as well.

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