What is "Diversification"? There is more to it than you might think!

Diversification basically means not putting all your eggs in one basket. If you hold only one stock and that company went bankrupt, then you would have lost all your money.  If you hold two stocks and one company goes bankrupt you have only lost half your money.  And so on, and so on.

But there is a BIT more to it than just that. If you held two stocks in companies like Sprint and Verizon and someone invents a device that makes phones obsolete, then both companies might go under.  In this case you have diversified by holding two companies, but you picked two companies in the same industry!

Further, if you held two mutual funds that both invested in large Canadian companies (and each fund held 100 stocks), but the Canadian economy as a whole declined, both your funds would lose money.

So there is more to diversification than just holding more than one stock.  The key to proper diversification is to pick different stocks (or other investments) that are NOT CORRELATED to each other. i.e. the values of each do not move in tandem. So when one is up, the other is down, and vice versa. (You still want to pick only investments that are expected to appreciate long-term.)

There are many different way to diversify – something known as “Multi-Level Diversification”. You can diversify by:

1. Holding more than one stock

2. Holding investments from different sectors (Telecom vs Banks vs Mining, etc.)

3. Holding investments in different Asset Classes (Stocks, Bonds, Cash)

4. Holding investments in different Markets (Canada vs US vs China vs Europe, etc.)

…and that is just scratching the surface.

So the take home message is that proper diversification means holding numerous securities that are as uncorrelated to each other as possible, in order to reduce risk. Let’s say that ALL investments in the universe returned 7% over the next 100 years, BUT each had their own “cycle” of when it was up or down in the short term.  If you held only one, then perhaps it made a killing in the first 50 years, but got slaughtered in the second 50 years. And maybe a different one returned 14% one year and 0% the next, and continued to alternate for the next 98 years in a similar fashion, and so on. Imagine that there are 1000 different investments in this universe and each has a very unique pattern of returns, but ultimately returns 7% over the 100 years.  Well if you held them all, you would still get your 7% over 100 years BUT you had a MUCH SMOOTHER RIDE and the variance of any annual return from 7% would be minimal.  Risk is another word for variance – so to reduce variance is to reduce risk – which can be accomplished with proper diversification.

Please note that you can not entirely get rid of risk and that the examples given in this post (as always) are fictitious and intended for educational purposes only.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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