Question of the Week – What is diversification?

In last week’s blog post we mentioned diversification. We briefly explained what it meant, but a few readers asked for a more in depth look at what diversification is and why it is important for all investors to practice.

You’ve likely heard the old phrase “don’t put all of your eggs in one basket.” The reason being if anything happens to that one basket you could lose all your eggs. That’s a simplification of diversifying your investment portfolio. Another way to look at it is that diversification reduces risk when it comes to investing.

Let’s say you have $10,000 to invest. Instead of diversifying, you invest the whole $10,000 in one stock as you expect it to be a real money maker. If the stock increases in value you’re golden. If it tanks you could lose most of, or possibly all of your investment.

To use a real world example, let’s say you invested all of your $10,000 in Black Berry in 2007, despite the recent launch of a new product by Apple called the i-phone. On March 2, 2007 you purchase 192 shares in Black Berry (then still called RIM) at $51.83 per share. By June, 2008 the price of Black Berry had climbed to $148 per share. Your risky investment has paid off! If you sold here you’d be looking at a healthy profit. If not, you’d be in trouble. In the next few years the price of Black Berry declined rapidly sinking to $50.30 by December, 2009 and it cratered to under $7 per share in 2013. The current price of Black Berry at the time this blog post was written was $9.82. If you still held your 192 shares they would be worth $1885, far less than your original $10,000 investment.

This is a very extreme example but it shows the immense risk in not diversifying your investments. If you were to spread your $10,000 around in different investments varying your risk you have a much better chance of balancing out or enduring any losses with positive gains.

Some ways to diversify your portfolio to mitigate risk include:

-investing in products with different risk factors

- investing in different asset classes

-investing in different industries

There’s no way to insure your investments will always make money. As we’ve said many times before all investments have risks. The best investors find a way to reduce that risk and diversifying is one of the best ways to do that. Whenever you’re thinking about a new investment think about how it aligns, or possibly doesn’t align with your current investments and your investment goals.