Portfolio Diversification

How to use portfolio diversification to mitigate risk:

We've all heard of the saying "Don't put all your eggs in one basket", because if something were to happen to that one basket, you would have no eggs left. However, if you split a dozen eggs between between 4 baskets, even if something happened to one of the baskets, you would still have 9 eggs left over.

The same is true for investing. Investing all your money into just one stock can be very risky, because if that company goes bankrupt or its share price decreases substantially, you would have lost a lot of money. Instead, to mitigate risks, investors often like to diversify their portfolios. They do this not only by owning many stocks, but by buying shares of companies, but buy buying shares of many companies in different sectors and industries, and sometimes even geographical regions (e.g. US, Europe, China, etc.) . This is because, if an investor were to invest in ten different technology stocks, but the market for tech companies is weak, they would still lose a lot of money, although, if they bought shares of companies that were in the technology, healthcare, infrastructure, energy and utilities, they would have a very wide range of stocks, and would be less likely to suffer from substantial losses.

"Diversification doesn't just minimize your odds of being wrong. It also maximizes your chances of being right." - Benjamin Graham

This quote shows how whilst it is true that you can mitigate the risk of an investment using diversification, you are also creating a cap on how much you can gain by investing less money in a good company.

The idea in portfolio diversification is that if one investment loses money, another, different investment can cover up the losses from that investment. For example if during covid you had an investment in an airline stock, such as EasyJet, but you also had a technology stock such as Alphabet (Google), your losses from EasyJet would have been covered up by your profit from Alphabet.

Portfolio diversification is not a perfect strategy however, because if you have one stock that did outstandingly well in a diversified portfolio, were you had to buy a lower amount of shares in that business, you would profit less than if you had bought more shares.

"Wide diversification is only required when individuals do not understand what they're doing" - Warren Buffett.

Warren Buffett is not such a big fan of diversification as he believes it also reduces the return on investment that can be made. Furthermore, finding many good business can be very difficult, time consuming and expensive (because of transaction fees). That said, ETFs have made this much simpler. Lastly, portfolio diversification can help reduce risk, but can not completely eliminate it. If the market is down in all sectors, whatever happens you will inevitably lose some money.

Despite this, diversification can be beneficial for long-term gains. This is due to the fact that if you have a diversified portfolio, in the long run you have an increased chance of doing well because you will have many very different stocks.

In conclusion, by having a diversified portfolio with varying companies spread across different countries, industries and sectors investors can protect their portfolio from a single very bad stock, and benefit from overall market growth. They are also able to build a more resilient portfolio that can weather market volatility with a long-term return.

This pie chart shows how an investor could potentially decide to diversify their portfolio by industry. This portfolio would enable them to have investments in a very big variety of different industries and sectors such as technology (perhaps Microsoft, Apple, etc.) and infrastructure (e.g. Union Pacific). This means that even if the market for real estate is not very strong, the other markets can compensate for that loss with gains.

The portfolio below shows a diversified portfolio by type of investments. US stocks with a high market capitalization is generally much safer, and US stocks with lower market caps are generally higher risk. Foreign stocks means companies in other countries (e.g. China, Mexico, India, etc.) This portfolio can help an investor to make money from multiple different type of investment fields.

Bibliography:

• Benjamin Graham quotes (author of the Intelligent Investor) (page 3 of 18) (no date) Goodreads. Available at: https://www.goodreads.com/author/quotes/755.Benjamin_Graham?page=3#:~:text=1%20Keeping%20your%20money%20spread,your%20chances%20of%20being%20right. (Accessed: 22 June 2023).

• Create a pie chart (2023) Create a Pie Chart, Free . Customize, download and easily share. Just enter the amounts, pick some colors/fonts, and we’ll take it from there! Available at: https://www.meta-chart.com/pie#/display (Accessed: 23 June 2023).

• Different Industries of Investments (no date) Google search. Available at: https://www.google.com/search?q=different%2Bindustries%2Bof%2Binvestments&rlz=1C5CHFA_enGB969GB969&oq=different%2Bindustries%2Bof%2Binvestments&aqs=chrome..69i57j33i22i29i30l9.6905j1j7&sourceid=chrome&ie=UTF-8&safe=active&ssui=on (Accessed: 23 June 2023).

• Lioudis, N. (2023) The importance of diversification, Investopedia. Available at: https://www.investopedia.com/investing/importance-diversification/ (Accessed: 22 June 2023).

• Patterson, L. (2023) Why a diversification strategy is important in uncertain times, VisionEdge Marketing. Available at: https://visionedgemarketing.com/skills-approaches-enable-diversification-strategy-success/ (Accessed: 22 June 2023).

• Warren Buffett - wide diversification is only required... - brainyquote (no date) Brainy Quotes. Available at: https://www.brainyquote.com/quotes/warren_buffett_173495 (Accessed: 22 June 2023).