Over the next few blog posts, we’re going to discuss the concept of portfolio diversification: what it is and isn’t, why it matters and how to do it effectively.
What Is Portfolio Diversification?
You may have heard the term “portfolio diversification”, but what does it mean? The Fidelity website provides a nice definition. It says,
“Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited.”
What does Fidelity mean by “type of asset?” In the investment world, there are ten investment asset types, but for simplicity sake, we’ll start with the three major ones. They are stocks, bonds, and cash. Let’s break it down:
- As you may know, a stock is a direct investment in a company. It’s partial ownership. If you own 100 shares of ABC Company stock, you own part of ABC Company.
- A bond is an IOU or loan you make to a company (or a government entity). If you own a bond issued by a company, you lend the company $XXX and the company promises to pay you back the same amount of money at some point in the future plus interest on the money you lent them in the meantime.
- Cash is legal tender – a mechanism that is legally accepted to pay for goods and services and to settle debts. Examples of cash are coins and dollar bills.
You may directly own a stock or bond, but most people own mutual funds or exchange-traded funds (ETFs) that own many stocks or bonds.
With that as background, why do we say diversification is spreading your investments around different types of assets? Now we are to the core of diversification.
A fundamental law of investing is that risk (the potential for the price of a security to go up and down) and return potential are related. That is, great return potential has the most risk and low return potential has low risk.
Stocks, bonds, and cash don’t have the same risk and return potentials and that’s why we say they are different asset types. Stocks have the most risk and return potential, bonds have less of both, and cash has very little of return potential and very little risk. Thus, “diversification “means spreading your investments among assets with differing return and risk potential.
One quick analogy: diversification is like what your shopping cart looks like as you go through the market: it contains, fruit, meat, and cheese. You eat all three, but they have different nutritional values and different prices. Just like you can have different types of fruit, meat, and cheese, you can also have different types of stocks, bonds and even cash. If they’re different enough, they add to a portfolio’s diversification.
In summary, portfolio diversification means owning different types of assets when measured by how much price risk and return potential each has. Remember: price risk and return potential are related.
Next time: Why Diversify?