Diversification: what it is and how it works
4 min read
Have you ever heard the saying "Never put all your eggs in one basket"?
What about the one that says "Never bet on just one horse"? You may never have thought that your grandma's advice could also apply to the world of investments.
Yet, that's right: you may have already figured it out, but today we’re uncovering one of the underlying principles of every wise and prudent investment: diversification!
Diversification is a strategy
Diversification is first of all a strategy, or a good practice that looks ahead, taking into consideration the right timing: the long-term one.
Let's add another concept: diversification is a strategy, which helps you to minimise your portfolio risk by dividing your assets between different investments.
There may be different ways to diversify, for example by resorting to different:
- financial instruments;
- financial assets;
- geographical areas.
It is important to say that diversification helps you to lower the degree of risk, but it does not eliminate it completely (and you shouldn't want to either, more on this below).
When do you need it?
Having talked about a strategy, a concept linked to the long term, should already have put you on the right track: diversification is not only useful when the market is turbulent, in which there are unforeseen circumstances that would otherwise risk ruining your bank account, but also in quieter and more common circumstances.
In short, diversification is always needed. Why? Let’s find out more.
Correlation between two variables is defined as "the degree to which the variables move in relation to each other.” Thus, you can understand why diversification goes in the direction of putting instruments in your investment portfolio that are as uncorrelated as possible: this is because it is in your interest that, at a given market moment, they do not move in the same way. It is best they move in two directions that tend to the opposite as much as possible, with the effect of balancing your overall portfolio.
In practice: if you are losing on one side, you are gaining on the other, with the effect of minimising the risk of your portfolio.
What is the purpose?
Contrary to what one might think at first, the primary purpose of diversification is not in fact to maximise earnings, but to protect against risks.
Of course, secondarily and in the long term, the outcome of diversification could also be that, but it is important to examine it in the right perspective.
Systemic and non-systemic risk
What are the risks that diversification can protect your investments from?
First of all, another important and not necessarily intuitive thing: although diversification will lower the risk level of your investment portfolio, it will not eliminate them all, and you shouldn't want that either!
Without any risk, in fact, the potential return is lower.
Coming to the types of risk against which diversification struggles:
- systemic risk is that which depends on elements and factors linked to the market, therefore are inherent to it. For example, if a banking crisis occurs and some banks default, they will most likely drag others with them, and so on. Therefore, it is not a risk that can be eliminated thanks to a good portfolio diversification, rather it responds more to the rule that one takes the good and sometimes even the bad of a situation;
- on the other hand, non-systemic risk is exactly what good diversification works on and against: it is in fact linked to specific, and not general, market factors. A specific factor is linked to the performance of a certain company and its stock on the stock exchange, as well as a specific financial asset (equity, bond, etc.).
You will understand well how diversification works by mitigating the risk deriving from betting everything on a single company, or on a single instrument. Now that the benefits and goals of diversification should be clearer to you, look at your investments in this light: can you do better?
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Oval does not provide investment advice and individual investors should make their own decisions. Seek the advice of a financial consultant if you are not sure about your investment. Your capital is at risk and the value of investments can go up as well as down and you may receive back less than your original investment: you should not invest money that you can’t afford to lose.