LEVEL: BEGINNER
The saying “don’t put all your eggs in the same basket” is arguably the most important piece of wisdom for investors. Time after time people who have had all of their money in one asset have been financially devastated from a market crash.
A recent and notorious example was the subprime mortgage crisis, when the value of millions’ of Americans homes fell by substantial amounts. Many people were financially devastated–and have still failed to recover–because the vast majority of their savings was kept as equity in their homes.
To avoid this type of financial ruin, savvy investors diversify. This simply means putting a little money here, a little there, and a little somewhere else.
Diversification and Risk
Diversifying to avoid financial ruin is one type of risk management. All investments have some level of risk, and they will tend to lose value in response to one or more types of events. However, there are few events that would cause all types of assets to fall in value at the same time. Other than a giant meteor hitting the Earth or a nuclear war, some assets will climb. Even the fall of Lehman Brothers, which saw some stocks fall by 90% in value, did not cause everything to lose value.
A portfolio with many investments in many different places will help minimize the fall in value from a negative economic event.
Diversification and Reward
At the same time, it is very difficult to know which assets will rise in value in the future. Unless you have a crystal ball, you can make very educated guesses about which companies will make money, which items will be in demand, and how this will impact the market, but no guess is ever 100% certain.
By diversifying amongst various companies, markets, and approaches to a business, you will become more exposed to different assets. The more assets you are exposed to, the likelier you will be invested in an asset that will skyrocket in value thanks to changes in the market.
Asset Classes
There are several asset classes beyond stocks. Real estate is an important asset class, as are bonds, currencies, commodities, and energy.
To truly diversify your portfolio, investors buy some stocks, some real estate, some bonds, and so on. These days, it is possible to diversify in this way with Exchange Traded Funds (ETFs) and Closed-End Funds (CEFs). A portfolio looking to maximize its exposure to various assets will look at various assets in addition to equity in growing companies.
This is because different asset classes will be affected by a crisis differently. No clearer case for this can be made than a closer look at what happened at the end of 2008. At the time, even the safest large-cap companies saw their stocks tumble in value. Even companies that had nothing to do with the crisis were in a free fall. Coca-Cola, for example, was down 28.41% for 2008, despite no significant change in its business or balance sheet.
This was largely due to a market panic, but investors can make money in market panics, too. While stocks were falling, bonds, particularly Treasury bonds, were way up. This is because investors were looking to put their money in a safe asset class that will not fall in value, and bonds are generally seen as a safe asset when economies are falling.
This does not mean investors buy bonds because they are investing in a market crash. Rather, it is part of an overall diversification strategy to ensure that the portfolio will make yield and continue to appreciate, no matter what happens in the economy or to an individual asset in the portfolio.
Rules of Thumb
How many stocks should a portfolio have and across how many asset classes is one of the persistent and most controversial questions in investing. The rule of thumb that has come from several mathematical models is that a portfolio should have 25 to 30 stocks.
However, diversification must be considered at a deeper level. Most investors also need to diversify across industries, nations, asset classes, company types, business models, and risk factors. The way that an investor diversifies with these considerations in mind is what makes the investor unique, and is what gives him or her an edge in the investing game.