A common misconception in investing is that diversification can be used to improve your returns. Although diversification by itself does not offer a way for investors to “beat the market,” this technique is instrumental for managing risk and avoiding a loss from having too many eggs in one single basket.
Warren Buffet’s cardinal rule for investing goes: “Rule No. 1: never lose money. Rule No 2: never forget rule No 1.” While investors could never hope to time to market or avoid owning investments at times when the market declines, we can make sure we don’t lose too much based on a development or surprise that unevenly hurts one company based on specific events or news.
By spreading your funds across different companies and assets, even when the most likely of events occurs, you will not find yourself losing a significant portion of capital because you had too much money tied up on a single investment.
Dealing With Market Risk
Even stable companies or blue-chip stocks often have surprises that could send their stocks soaring. Take AT&T and Verizon, for example, who saw their stocks hit twenty-year lows this year after reports surfaced about possible lead seepage and contamination from old telecom wires across the country. Or take Raytheon, a giant defense company that saw their stock tank recently after malfunctions were found in their widely manufactured jet engines, which has their stock down almost -30% this year.
When you take a huge loss on an individual stock, it can sometimes take years or even decades to make it back up. That’s why losing money from betting too heavily on one large allocation in your portfolio is a cardinal sin, as Buffet implies.
Riding the Waves
Beyond avoiding specific company risks, the economy has its ups and downs, which could be helpful or hurtful to a variety of different assets- such as stocks, bonds, commodities, cryptocurrencies, real estate, or interest rates. When one type of investment is down, another is usually up. Diversification across assets helps balance out these swings over time and could often reward a portfolio that isn’t only chasing the latest fads that often prove to be overbought and overpriced in the long run.
Isn’t This Just Playing It Safe?
Yes, and that’s the point! We all dream of hitting a jackpot with a super-successful stock or investment. But betting everything on one possibility is dangerous and will likely turn investing into gambling. Diversification is about smart and steady growth. It’s like planting a garden with different types of plants. The beauty of the market and economy is that it is resilient over the long run, but risk assets such as company stock and cryptocurrencies don’t always recover and sometimes even become worthless.
Josh is the owner and lead writer at Daily Wisely. His career has taken him from finance to blogging, and now shares his insights with readers of Daily Wisely.
Josh's work and authoritative advice have appeared in major publications like Nasdaq, Forbes, The Sun, Yahoo! Finance, CBS News, Fortune, The Street, MSN Money, and Go Banking Rates. Josh has over 15 years of experience on Wall Street, and currently shares his financial expertise in investing, wealth management, markets, taxes, real estate, and personal finance on his other website, Top Dollar Investor.
Josh graduated from Cornell University with a degree from the Dyson School of Applied Economics & Management at the SC Johnson College of Business.