What is diversification?
Nick Murray once explained it this way: if you invest only in sunscreen, you may go bankrupt if there is a long period of rain.
However, if you are invested in sunscreen and umbrellas, you have some protection against the effects of the weather.
And if you also invest in snow shovels, you have also reduced the risk of the changing seasons.
In essence, this is the purpose of diversification: to reduce risk.
No one can guarantee outcomes. Thankfully, if you’re properly spread out, you don’t have to.
You won’t strike it rich when it’s sunny. But you also won’t be bankrupt when it rains.
How do we experience diversification?
Diversification feels pretty anticlimactic. You don’t experience massive overnight gains or the excitement of your singular stock soaring to unprecedented heights. It often feels like other people are doing better than you.
However, you also don’t feel the flip side. You don’t feel the crushing loss of your only stock plummeting. You don’t go bankrupt along with the company you’re invested in.
You probably won’t make it on the billionaires list if you’re diversified. But you also won’t take on the massive risk the people on that list do. To become a billionaire, you have to risk millions, constantly. Sometimes it pays off, and sometimes it doesn’t.
We only hear about the people who are doing well. But the truth is, there’s a reason the list of billionaires is constantly changing. It is very easy to place your bets on something and lose.
So, as Nick Murray says, diversification won’t make you a killing, but you also won’t get killed.
Why is it important?
Diversification is, in essence, accepting that it is extremely difficult to outsmart the market.
Investing in one stock, regardless of how much you know about it, opens you up to huge risk. Even if you work at the company or analyze it day and night, you can’t reliably predict the future or how market activity will influence the stock.
Thankfully, when you are diversified, you don’t have to.
Spreading your investments across a broad range of countries and industries protects you from being crushed by the performance of one stock. Even if one stock suffers, it’s highly unlikely that your entire portfolio will drop to zero.
Diversification is the buffet of investing. Instead of buying a $50 entrée that you don’t know if you’ll enjoy, you get to try a little bit of everything. And even if you don’t like something on your plate, it’s not the only thing on your plate.