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3 Reasons Diversification Is an Investor's Best Friend
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3 Reasons Diversification Is an Investor's Best Friend

3 Reasons Diversification Is an Investor's Best Friend

You can grow your wealth significantly through investing, but depending on your allocation, you could experience a bumpy ride. You trade risk for reward hoping that you can avoid losses, but bypassing them altogether is incredibly difficult.

You can, however, lessen them. If you are someone who prefers a smooth investment journey, here are three ways diversification can help.

Image source: Getty Images.

1. Diversification lowers your risk

When you own only one or two stocks, you could have a really big win if the stocks do well but you could also lose a lot if they do badly. If you're not comfortable with that trade-off, you can lower your risk through diversification.

In 2008, during the financial crisis, if you only owned stocks like Bear Stearns or Lehman Brothers, you would have seen your portfolio value hit zero. If, however, you owned all the stocks in the S&P 500 spanning multiple industries through an ETF like SPDR S&P 500 ETF (NYSEMKT: SPY), then your accounts still would've declined in value, but only by about 37%.

Adding more securities to your portfolio helps you mitigate concentration risk, assuming that they aren't all the same type of stocks. Diversification looks different for everyone, and there is no rule of thumb for how many stocks you must own. But research has shown that by equally weighting 20 different stocks, you can reduce your volatility greatly.

2. Diversification can increase your exposure to different asset classes

Historically, cash has been less volatile than bonds, and bonds have been less volatile than stocks. You should get the most reward in the long run for holding stocks because they involve the greatest level of risk. But that doesn't mean that they always perform the best over shorter periods of time.

In bull markets, asset classes with the most risk perform well, but in bear markets, those with the least risk are often considered safe havens and can outperform. For example, in the first part of this year, when the stock market plummeted due to fears of the coronavirus, fixed income products fared better than stocks. Predicting which year will bring a bear market and which will be a bull is impossible. That's why increasing your exposure to different asset classes by owning some or all of them is a great strategy.

If your portfolio is properly diversified, it will go beyond just allocations among major asset classes like stocks, cash, and bonds. You'll also need to diversify within those asset classes. For instance, owning stocks in different sectors, mixing large cap and small cap stocks, and having some U.S. and some international stocks in your portfolio will help you get the widest investment exposure.

3. Diversification can smooth out your return

By increasing the types of investments you own, thus lowering your risk, you can actually enhance and smooth out your return. Imagine you have $100,000 to invest in either a portfolio of all stocks (portfolio A) or a portfolio of half stocks and half cash (portfolio B).

You will be rewarded with portfolio A by earning twice as much in positive stock market years, but you will also lose twice as much in years where the stock market is negative. After one year of big losses, followed by one year of big gains and then one year of moderate gains, portfolio B has a higher final amount than portfolio A.

PortfolioYear 1Year 2Year 3Final Amount
Portfolio A(40%)30%12%$87,360
Portfolio B(20%)15%6%$97,520

Data source: Author calculations. Assumes cash held in portfolio B has no return based on recent interest rates.

Why? Because there is value in limiting your losses; doing so can get you back into positive territory sooner. Smoother returns can make you more likely to stay the course rather than sell your investments at the wrong time because of your emotions.

You work hard for your money, and seeing your account value decline is tough, especially if it makes it harder for you to meet your financial goals. Volatility is a part of investing, but limiting it while still making money is possible. Finding your perfect mix of risk for reward is a delicate balance, and diversification is the tool you use to find it.

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