The Importance Of Diversification

3 minute read

Eggs, Baskets, and Diversification

Don’t put all your eggs in one basket. This is a very well-known saying, especially in investing. The idea behind this (fair) warning is simple: Diversification is important. If you put all your effort or assets (the eggs) in one place (the basket) and fail, then the consequences of failure are catastrophic — and we don’t mean egg yolk splashing everywhere.

You’ve essentially put yourself in a position where you have no alternative. No plan B.

This is a key principle. It will follow you throughout your investment career, and throughout life in general.

Whether we are talking about investing money or applying for jobs, always spread your efforts and reduce the risk of a single idea, project, or investment failing.

Can you diversify in the stock market?

In our post about stocks, mutual funds, ETFs, and indexes we explained how indexes are a representation of a group of companies belonging to one sector, industry or geography, and how ETFs can be bought & sold on the stock market.

It is precisely this property of an index that makes it a naturally diversified investment vehicle.

The failure of one company in an index does not automatically result in the failure of the entire index. Only when the entire sector, industry or geography covered by an index fails do you actually lose your money. And that, as you can imagine, is a lot more unlikely (but not impossible) than one company in the index failing.

So, in summary, although individual stocks are volatile and can be risky, spreading your eggs across many baskets offers you intrinsic protection against bad bets. And one such way of spreading your eggs is by investing in indexes rather than individual stocks.

How does one actually invest in diversified indexes?

At this point, you may be wondering whether you can actually invest in ETFs that behave similarly to indexes. The answer is, yes! There are hundreds of ETFs out there that represent specific indexes, all of which are available to the public for purchase.

Two popular examples of such index ETFs include SPY, which is an ETF that tracks the S&P 500 index, and VTI, an ETF that tracks the entire US stock market or roughly 3,400+ companies listed in the US stock market.

If you Google a few sectors, such as renewable energy, oil, cars, electronics, tech, etc… you will quickly come up with a huge list of ETFs to help you invest in these sectors.

The same applies for geographies. Do a Google search for “Brazil ETFs” and you’ll get a list of ETFs that track the economy in Brazil.

Are indexes the only way to diversify?

Although indexes are an easy way to diversify, they are not the only tool at your disposal. Other ways to diversify investments include:

Picking stocks manually: I wouldn’t recommend this, unless you know what you are doing and have plenty of time to manage your portfolio. The primary reason against this is that you will need to be so good at picking companies & sectors and balancing how much you invest in each (and let’s face it you wouldn’t be reading this post if you were that advanced). The second reason against this is that you would require lots of time to constantly monitor & manage your picks.

Ensuring you don’t invest your entire net worth in stocks alone: Think of stock/ETF picks as toppings on a pizza. Sure, you want a variety of diverse toppings, but there’s no need to have only pizza, is there? What if you want pizza & burgers? Pizza and fries? Pizza and shawarma? Diversifying your investments one level above stock picks and ensuring that your money is invested in stocks, bonds, real estate, gold, start-ups, yourself, etc, is another way to diversify properly.

Conclusion

The bottom line is that unless you are absolutely certain of a specific investment strategy, it is wise to limit the proportion of your full net worth into it. And because most investment strategies are never absolutely guaranteed, it becomes wise to diversify your investments all the time.

On the other hand, there should be a strategy of investing that automatically manages diversification for us, especially if we don’t have the time or patience to baby sit investments on a daily (or even weekly) basis. This is definitely something we will get into in the next few blog posts. So stay tuned.

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