How important is “Diversification” in investing?
These days, a lot of investors seem to be “in love” with stocks as an investment asset. This is not bad per se, but intelligent investors understand that portfolio diversification is a critical element of an overall investment strategy.
What is “diversification”? Simply speaking, diversification means investing in a variety of assets to reduce portfolio risk. Risk here refers to the possibility of loss or reduction of investment capital.
The saying “Don’t put all your eggs in one basket” aptly summarizes the theory of diversification.
What “Diversification” means
A primary assumption of diversification is that asset classes, such as stocks, bonds, real estate, etc., do not move in similar directions. This means when the price of one asset class goes up, you cannot expect the price of another asset class to go up with the same momentum.
Consider stocks and bonds. During bullish periods, while stocks may achieve double-digit growth, bond yields may also rise, although at a slower single-digit growth.
Similarly, when one asset class declines in value, other asset classes do not necessarily lose the same value too. This imperfectly correlated relationship provides the benefit of diversification.
Let’s cite a practical example to explain this concept more clearly.
Benefits of Diversification
Scenario 1: Let’s assume you invested one hundred thousand pesos (P100,000) in stocks.
During one bearish period, your stock’s portfolio value declined by 10%, which means you are incurring a paper loss of P10,000.
Thus, the current value of your stock investment is P90,000.
Scenario 2: Let’s assume, this time, that you chose to diversify and equally divided your P100,000 investment in stocks (P50,000) and another P50,000 in bonds.
During a bad economic cycle, let’s say stocks declined in value by 10%. For your stocks investment, you would lose P5,000, computed as follows:
- P50,000 principal invested in stocks x 10% loss = P5,000 loss
Bonds, meanwhile, normally won’t decline with the same momentum, and let’s assume they declined in value by just 6%. Your bond portfolio is down P3,000, computed as follows:
- P50,000 bond investment x 6% loss = P3,000 loss
Considering this loss, your bond investment is currently valued at P47,000.
Combining the values of your stock and bond investments, your total portfolio is valued at P92,000, computed as follows:
- Current value of your stock investment: P50,000 – P5,000 loss = P45,000
- Current value of your bond investment: P50,000 – P3,000 loss = P47,000
- P45,000 value of stocks + P47,000 value of bonds = P92,000 total portfolio
As you can see, a diversified portfolio provided you some buffer against risk.
Your diversified portfolio is valued at P92,000 — higher than the P90,000 value of the earlier portfolio that was entirely invested in stocks.
Looking at it at a loss perspective, in the second scenario above where you opted for diversification, your total unrealized loss was P8,000.
In the first scenario where there was no diversification (fully invested in stocks), you incurred a higher loss: P10,000.
Such is the benefit of diversification: it minimizes the risk or the possibility of loss in your investment.
Disadvantages of Diversification
We’ve seen the benefit of diversification, but are there downsides to it?
Yes, there are.
In the same way that risk is reduced, diversification also reduces the total profit potential you might earn.
Following the same example above, if stocks went up by 10% and bonds grew by only 6%, if you are fully invested in stocks, you will be able to take advantage of the high growth in stocks.
If you’re fully invested in stocks, your income will be P10,000 given a 10% return, computed as follows:
- P100,000 principal invested in stocks x 10% gain = P10,000 profit
However, if your investments are diversified and you invested 50% in stocks and 50% in bonds, you won’t be able to take full advantage of the high profits of stocks.
Half of your investment (stocks) will increase in value by 10%, but the other half (bond investment) will only grow by 6% — leading to a slightly lower total portfolio return. The total profit of this portfolio is only P8,000 computed as follows:
- P50,000 principal invested in stocks x 10% gain = P5,000 profit
- P50,000 bond investment x 6% loss = P3,000 loss
- Total profits = P5,000 + P3,000 = P8,000 gain
As you can see, the diversified portfolio provided lower profits (only P8,000 gain) compared to the earlier portfolio that is fully invested in stocks (P10,000 gain).
To diversify or not to diversify?
Diversification can indeed help minimize risk or possibility of loss, but it can also lower your potential return. It’s now up to you if you want to trade returns for risks.
- If your priority is to minimize loss, then choose to have a diversified portfolio.
- If you prefer higher returns, you may choose not to diversify but be ready to take on higher risks as well.
Happy smart investing!
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