Investing · May 14, 2020

Diversified Investments: What They Are and Why They Matter

Risk and reward go hand in hand when you're putting together an investment portfolio. Generally speaking, the higher the potential reward, the greater the risk involved. A sound investment strategy offers high potential returns while exposing you to a level of risk that you're comfortable with.

Diversification is one of the most common and useful strategies for achieving this goal. Making sure you have diversified investments helps spread out your risk, so you're not reliant on one company or industry to perform well for your portfolio to yield good returns.


How diversification impacts risk

Investments fluctuate in value with changes in the market. These shifts can include large-scale economic events, such a global financial slowdown, political unrest or changes in exchange rates. This is known as undiversifiable or systematic risk, because it affects the entire market system. Diversification isn't designed to mitigate this type of risk—it's simply something you accept when you begin investing.

However, there are also economic trends that only affect certain industries, countries or companies. For example, a new technology that seemed to have a lot of promise might not end up being as successful as expected, or a particular country's economy may slow while others remain healthy.

These are considered forms of diversifiable risk, because they're of the type that diversification aims to minimize. When you diversify your investments across a range of industries and companies, you're not dependent on a single type of investment, and your assets won't all react the same way to market events that fall under the category of diversifiable risk. So while one investment or set of investments may not perform as well as you hoped, another may end up being stronger than expected, and you may still yield positive returns on your overall portfolio.

Diversification in action

Let's say you have $1,500 to invest. A pharmaceutical company called Top Rx announces it's releasing a revolutionary new drug, and you decide to invest half your money in their stock. Buzz builds as the projected release date gets closer, so company's stock goes up by 2%, and your investment grows.

Unfortunately, the FDA doesn't approve the drug. Now, Top Rx can't release it when planned, and its stock drops by 5%. The stock is down by 3% since the time you purchased it.

Luckily, you put your other $750 in stock for OrangeTech, a tech company whose new smartphone is skyrocketing in popularity. The company's stock is up 9%. So, the initial $1,500 you invested has grown by 6%. Yes, you've lost money on the Top Rx investment, but despite everything not going perfectly, you've still made money overall.

Picking the right mix

Diversification doesn't need to just be about companies and industries. You can also choose a mix of US or foreign stocks, bonds and commodities.

  • Stocks: Stocks give you an ownership stake in the company, and they tend to do best when the company and the economy are strong. A diverse stock portfolio consists of small, medium-sized and large companies in different industries. Further diversifying your investment by along these lines may spread out your risk more.
  • Bonds: When you buy a bond, you're loaning money to the bond issuer. US treasury and savings bonds are among the safest investments you can make, because the federal government guarantees them. Corporations also issue bonds. These have better returns but come with more risk.
  • Commodities: These include gas, oil, real estate and precious metals such as gold. Commodities are typically riskier investments, but they can be useful because they tend to remain strong during times of economic downturn or uncertainty, when stocks and bonds typically take a hit in their performance.

Finding the right balance for your goals

So, should you put most of your money in stocks? Or should you split it evenly across stocks and bonds?

The answer here depends on how much risk you can tolerate. More risk typically means greater potential for returns, but it also theoretically increases your chances of losing money in the event that political or economic investments negatively impact the market.

One common approach is to start with safer investments, such as US treasury bonds and fixed annuities, and grow from there. Even better, consider speaking to a financial advisor. They'll discuss your risk tolerance, needs and goals and help you work out what type of investment portfolio would suit you best.

Market conditions change, and investments fluctuate. Diversification can help you make the most of the good times and weather the leaner ones, so that your investment portfolio continues to help you build the future you want.

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