With the economy and markets getting more volatile and a lot of investors growing skittish, I’m starting to hear more talk about the importance of diversifying investments. I hear many people referring to diversification as the key to long-term investment survival and success.
But the more I discuss diversification with people, the more I realize that most of us haven’t put a lot of thought into the topic.
Yes, diversification reduces risk. There’s no argument there. In fact, that’s the single biggest goal and benefit of diversification—reducing exposure to risk.
But does that mean we should all diversify our investment portfolio? And if so, how much diversification is the right amount?
Finding the Sweet Spot of Diversification
Good investors and business owners think about diversification as an insurance policy.
Essentially, it is. It’s an insurance policy for your portfolio.
So, let’s replace “diversification” in the question above with “insurance.” Do we all need insurance? If so, how much is the right amount?
When we think of it in these terms, the answer is obviously, “It depends.”
Remember, just like with an insurance policy, there is one major downside to diversification: it’s not free.
Diversification will cost you money in terms of reduced returns. If I diversify my investments into five different asset classes, it’s unlikely they will all perform equally. Some will generate higher returns than others. And the lower-return asset classes will bring down the average returns that the higher-return asset classes provide.
But that’s the trade-off we make in order to reduce our overall risk. Just like we shell out cash every year for an insurance policy that we may or may not need, it protects us in case something DOES go wrong.
Determining When Diversification Is Necessary
Now that we’re thinking of diversification like an insurance policy, let’s consider when it’s needed and to what degree.
Diversification is necessary:
When we have other people depending on us, we can’t afford to subject them to the risk of losing everything.
Most of us think about life insurance when we’re married and have minor kids. But when it’s just us, there’s less concern about dying. This holds true in our business and investments, as well. If other people are depending on us to not allow our businesses to “die,” diversification is a lot more important.
When we’re knowledgeable and diligent about staying healthy, our risk is lower.
Health insurance is much less important for those who understand how to keep their body in good shape and actively work at it. If I understand the basics of nutrition and I work out every day, I may be able to save some money by having a high-deductible health insurance policy—or perhaps no policy at all.
Likewise, if we understand what makes a good/bad investment and we work hard to keep our investments on track, diversification is much less important. Our risk is inherently lower.
When we get older, we need to be more cautious.
Someone who loses everything at 25 has decades to rebuild their portfolio and plan for retirement. Someone who is 55 doesn’t have the same luxury. As we age, diversification becomes more important simply because we don’t have the time to rebuild should we lose it all.
When we have less control, we need more protection.
Firefighters, police officers, and soldiers all face risks that are out of their control. For that reason, they better make sure they’re paid up on their insurance. On the other hand, accountants, computer programmers, and cashiers have a lot more control over the risks to which they are exposed, so insurance is less of a necessity.
Likewise, investors who have more control over their investments are less in need of diversification. If you invest in the stock market, where you have essentially no say in the decisions made by the companies in which you invest, you’re probably going to want your portfolio to be highly diversified. But if you self-manage rentals, you may have enough insight and control over your investments that diversification isn’t needed.
Each of us needs to evaluate our personal and financial situations, our investments, and our businesses individually in order to decide what amount of diversification is right for us. Understanding that diversification is simply an insurance policy for our portfolio can provide an appropriate framework to help determine the right trade-off between risk and reward.
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