Why diversification matters and why all forms of diversification are not created equal.
Why does diversification matter when investing? Over and over again investors are told to ‘diversify’, but why?
Diversification matters because fighting off your back is much more difficult than fighting on your feet in the financial markets. What do I exactly mean? If your portfolio takes a significant loss (puts you on your back), it will take twice the return compared to your loss to regain your original position (get back on your feet).
- Example: $5,000 loses 50% – Now worth $2,500.
- To regain the $5,000 you started with your $2,500 must bring a 100% return on investment.
Being diversified helps protect you from these very detremental losses. You want to be able to focus on advancing your portfolio’s position, not regaining ground you’ve lost. Sometimes the best offense is a good defense.
All diversification isn’t created equal?
If I hold an oil, natural gas, geothermal, and wind power company do I hold a diversified portfolio? Yes, I do, but is this the diversification that we’re referencing above? Not really. This form of diversification is sector specific. I have a diverse set of investments from the energy sector. That’s nice, but if energy prices trend downwards, then most likely all of my holdings will, as well.
To provide a good defense mechanism against portfolio losses, you need a broad based form of diversification. This means going beyond specific industries and sectors and into different markets and investment vehicles.
This is can be a very deep topic, since the level of diversification will differ between investors and the measurement of a portfolio’s diversification can be some what subjective and can hinge upon the notion of how strong the correlation is between different investments is in the portfolio.
Main point – A well developed diversified portfolio will create the ‘defense’ you need to avoid excessive losses compared to the rest of the market.