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.

To summarize:

  • 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!

Must read these other awesome educational articles!

About the Author

PSEi support seen at 6,200 and 6,000 amid weaker Peso

In a not-so-surprising move, the U.S. Federal Reserve (Fed) yesterday raised interest rates by 75 basis points (bps) or 0.75% in a bid to tame rising inflation in the United States. This was the third consecutive 0.75% rate hike by the Fed, which brings the federal funds rate, the central bank’s benchmark interest rate, to ... Read more

Official SWIFT Code of BDO, BPI, Metrobank, Philippine banks

When sending cash remittances or wire transfer to a bank account in the Philippines (such as BDO, BPI, Metrobank, Landbank, DBP, etc.), you’ll surely need the SWIFT Code of the bank. Look no further because you can find all the SWIFT Codes you need in this list! Make sure you’re using the right bank code ... Read more

How to Waive your Credit Card Annual Fee (BDO, BPI, Metrobank, RCBC, Citibank, UnionBank)

Without a doubt, one of the most annoying fees that credit cardholders have to pay is the annual fee. Majority of cardholders are familiar with this fee and majority of us likely pay this grudgingly year after year after year. In the case of my credit card with BPI (Bank of the Philippine Islands), I’m ... Read more

Why Filipinos do not become business owners or entrepreneurs

For a majority of Filipinos, entrepreneurship does not seem to be a typical, expected path. This is not surprising, considering that in school, students are primarily taught to become employees after graduation. Students train for years to become staff workers, reporting to a supervisor, and just waiting to receive their wages or salaries every month. ... Read more

My experience investing in Mutual Funds in the Philippines

I started investing in mutual funds when I was 22 years old. As an Overseas Filipino Worker (OFW) then, I was fortunate to be able to save some money at that young age because of my work abroad. One time while I was on vacation in the Philippines, I saw a large billboard in EDSA ... Read more

Income Tax Tables in the Philippines (2022)

The Philippines’ new tax reform bill, known as TRAIN or Tax Reform for Acceleration and Inclusion, was signed into law on December 19, 2017 and its implementation began on January 1, 2018. What are the new income tax rates under the TRAIN law? How will TRAIN affect income taxes of individuals and corporations? How is the ... Read more

PSE Stocks Performance under each Philippine President (1987-2021)

Did you know that Philippine stocks were able to achieve an astounding growth of 800% in a span of 30 years? From 1987 until 2018, the Philippine Stock Exchange index (PSEi) rose from 1,000 points to a peak of 9,000 points — generating a return of 800% over 30 years. (The PSEi is an index ... Read more

SSL 2022: Salary Increases for Teachers, Nurses, Gov’t Employees

Good news to all government employees! There’s a new round of salary increases beginning January 1, 2022! Millions of employees of the Philippine government — including public school teachers, nurses and staff of government hospitals, and workers in local and national government agencies, etc. — will be getting an automatic salary adjustment this 2022 under ... Read more

PSE Trading Hours in 2022: What time open, when closed?

Before you take the plunge into stock trading and investing, make sure you understand what stocks are and how the Philippine Stock Exchange (PSE) operates. Unlike other investments that are relatively safe, stock trading is risky and loss of money is a possibility. So before you deep dive into the exciting world of stock trading, ... Read more

Price Floor and Price Ceiling of PSE Stocks

Trading bands in the PSE come in two forms: Price Ceiling, or the upper price limit, and Price Floor, or the lower price limit.

1 thought on “How important is “Diversification” in investing?”

Leave a Comment