You’ve probably heard the term “diversification” somewhere before.
As the name suggests, diversification means spreading your investments across different assets. But why should we go to the trouble of doing that?
The truth is, in investing, size matters. The more money you invest, the greater the potential return if the investment succeeds.
However, not many individual investors can afford to invest large sums of money all at once. This is because, if the investment fails, the losses could be significant.
In contrast, diversification is a more approachable strategy. The primary purpose of diversification is to reduce risk.
It is commonly said that “risk and return are balanced” when it comes to investing. If a high-risk investment pays off, you can earn substantial returns. However, because the chances of success are low, these investments are considered high-risk.
On the other hand, low-risk investments typically offer lower returns, but the expected return is more stable. For example, bank deposits today offer almost no interest because the risk of a bank failing is extremely low.
When people hear the term “diversification,” many might think, “Just spread the investments around.” As a result, when attempting to diversify, most people simply end up dividing their investments across several products. In reality, true risk diversification is rarely achieved.
For example, imagine someone investing in stocks who thinks, “I’ll diversify my risk by investing in Toyota, Honda, and Nissan.” Unfortunately, this does not constitute diversification.
While the investor is indeed spreading their money across multiple companies, stocks within the same industry tend to move in similar ways. In other words, if one stock goes down, they are all likely to go down together, which means it’s not true risk diversification.