Investment Fundamentals: Diversification

January 13, 2015

They say variety is the spice of life. But when it comes to investing, variety can be a key to long-term success.

  • Diversification is a way of managing risk that may be a key to long-term investment success.
  • In simple terms, it means not putting all your “eggs” in one “basket.”
  • There are several ways to diversify your investments.

They say variety is the spice of life. But when it comes to investing, variety can be a key to long-term success. This is why so many investment professionals advertise diversification as a benefit of their products, or services. But just what does diversification mean? And why might it be beneficial?

How Diversification Works

Diversification is a means of managing risk.

Simply put, diversification is a means of managing risk. The concept is as simple as the age-old analogy (or, cliché) of not putting all your eggs in one basket. Imagine your goal is to move your eggs from Point A to Point B. If you put all your eggs in one basket, you run the risk of dropping that single basket—and losing all of your eggs. If you spread your eggs across several baskets, however, you have reduced the risk of losing all your eggs if a basket is dropped—since you have extra eggs, safely tucked in other baskets.

Think of your money like eggs, and asset classes like baskets that can carry your money from Point A (your current portfolio) to Point B (your investment goals). Each asset class (such as stocks, bonds and cash) has unique characteristics that cause it to perform differently under different market conditions.

Investors who put all their money (or, eggs) in one asset class (or, basket) run the risk of losing a significant amount of money—as that particular asset class may or may not perform well in a given market condition. Those who diversify their investments across a range of asset classes, however, would likely have some insulation against adverse market conditions.

Diversify your Diversification

Diversification can be taken a step further by allocating investments across categories within the broader asset classes. (See Exhibit 1 for a hypothetical example.) Since different types of bonds are inherently more volatile (high-yield bonds, for example) than others (investment-grade bonds, for example) investors could benefit from allocating their money across bond types, according to their level of risk tolerance. Also, because performance of both stocks and bonds in a given period might be affected by where the holdings reside, investors can benefit from allocating both asset classes across different regions or countries.

Exhibit 1:
asset allocation/diversifying withing broad asset classes

 

 

 

 

 

 

 

*Global Developed Equities includes Asia-Pacific, U.S. and European Developed Equities.

While diversification may not always protect against market risk, the more layers of diversification that exist within a portfolio, the more likely the portfolio will have a layer of defense against market volatility.

What This Means to You

With perfect foresight, you could simply allocate all of your money to the top-performing asset class each year. Without this divine ability, however, the best option is to invest in a variety of assets (or sub-asset classes, regions or countries) that overall meet your risk-tolerance levels and react differently to a range of market forces. This serves to moderate the ups and downs of portfolio performance, giving you a better chance to reach your long-term goals.
In a series of future papers, we will delve deeper into the different ways to achieve diversification—covering pitfalls to avoid and methods to strive for.

More from the Investment Fundamentals Series

Legal Note

#

Information provided by SEI Investments Management Corporation (SIMC), a wholly owned subsidiary of SEI.

This information should not be relied upon by the reader as research or investment advice, nor should it be construed as a recommendation to purchase or sell a security.

There are risks involved with investing, including loss of principal. Bonds and bond funds will decrease in value as interest
rates rise.

Diversification may not protect against market risk.