The Importance of Diversification

Weve all heard the cliche: Dont put all your eggs in one basket. The basic premise is that if that one basket were to break or be dropped, it would ruin all your eggs. Instead, use multiple baskets so that a single unfortunate accident wouldnt ruin everything you worked so hard for.

The same is true with your hard earned money. Dont put all your money into the same account or investment vehicle. The technical term for this is diversification, but that is a broad term that can involve a few different strategies.

Asset class diversification is the first type well look at. The asset class is simply the type of investment youre using. Are you putting you money into a stock (share in a company), into a mutual fund, a bond, a guaranteed investment certificate (GIC), etc. The reason diversification is important here is that different assets classes have varying degrees of risk and reward. A GIC is a way to guarantee a return (thats what the G in GIC stands for), so this would be considered a low-risk asset class. While there is no way to lose money on a GIC, some would argue that the risk involved with these is the incredibly low return. By playing it too safe, your money will grow at an incredibly slow rate, sometimes barely the rate of inflation. A stock, on the other hand, can give you explosive returns. It is not uncommon to see certain growth-oriented stocks bring in more than a 100% return in a single year. The risk here, obviously, is that you could just as easily lose it all. For each company giving you a 100% return, there are twenty who will go out of business. By choosing to save money using various asset classes, youre able to enjoy the safety of low-risk low-reward assets, while still growing your money through the riskier world of stocks.

Industry diversification  is the second type of diversification well look at. This relates to the types of stocks that you buy. When deciding which companies to invest in, wise investors will select companies from different industries. Get some shares in technology stocks, some in energy, and some in financial services, etc. This strategy protects you against an industry-specific event that could ruin your investment. Currently as I write this, the oil industry is struggling due to low oil prices. Also every oil companys share price has crashed over the last couple of months. Someone who invested only in oil companies would have lost a significant percentage of their savings. By having shares of companies from a variety of industries, you can still enjoy growth from the other industries while you wait for your struggling industries to recover.

The final type of diversification I will discuss is geographic diversification. Just like we talked about with industries going through hard times, its also possible for countries or geographic regions to be hit with an economic downturn. Its often wise to purchase shares in companies from a variety of countries to make sure that your investments will continue to grow even if the economy of one single country begins to struggle.

Diversification is an absolute must for investors to protect their hard earned money. There are a lot of complex strategies around this topic, but these basics should put you in a good position to build a well-guarded portfolio. In a future post, Ill talk about investment-horizons, asset class weighting and other more complex topics.