The Importance of Diversification

Date: 4/1/2022

Diversification, as defined by Investopedia, is a technique that reduces risk by allocating investments across various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Without the critical investing strategy, investment profits in the long term are unlikely. Diversification is a strategy centered around lowering one’s risk of losing money due to one volatile investment pick. For example, if an individual invests their entire portfolio each transaction into only one asset, their investment must be profitable each and every time in order to not lose a large sum of their profits after all expenses are accounted for. This is the same scenario if, for example, an individual only invests in stocks from one industry. Because share prices usually drop according to future insights or bad news per industry, large sums of profit can be lost due to one piece of unfortunate or unexpected news.

Because of this, it is strongly recommended to invest among different asset classes. An asset class is a grouping of investments that exhibit similar characteristics and are subject to the same laws and regulations. Different assets react in different ways to certain events. For example, if the economy is in a state of decreasing inflation and decreasing growth, it would be advisable to invest in long-duration government treasuries because of their non-volatile nature and little to no risk, since the government can always print out more money if you wish to sell your investment. However, during a period of decreasing inflation and increasing growth, developed equities such as stocks are recommended because they will reflect the highly desired economy through large sums of profit.

Therefore, if you diversify, unpleasant price swings will be offsetted by positive results in another industry or asset. Location can be another form of diversification. Though United States listed stocks are most reliable, there can come a time when they are underperforming in relation to equities from another part of the globe. Ray Dalio’s ‘Holy Grail in Investing’ nicely summarizes the importance of the strategies listed above.

Though the chart can look confusing at first, its message is quite clear after looking at the summarizing data table on the right. It basically states that as an investor increases the number of uncorrelated assets in their portfolio, their probability of losing money in a given year decreases. An uncorrelated asset can include commodities and bonds or stocks in various industries. After around ten uncorrelated assets, your loss probability becomes vastly minimized in relation to only owning one. Because of the dramatic decrease in risk, long-term holding using the principle of diversification is the most effective and globally accepted method of profitably investing.

For additional information, purchase the book titled Beyond Diversification by Sebastien Page linked below.

Works Cited

Barrow, Alex. "Ray Dalio's Portfolio Allocation Strategy: The Holy Grail." Macro Ops, 27 Sept. 2017, Accessed 5 Mar. 2022.

Eaton, Tina. "A Modern Guide to Portfolio Diversification." Kubera, Accessed 5 Mar. 2022.

Iadeluca, John. "Diversify Crypto Portfolios with the World's Biggest Hedge Fund's 'Holy Grail' Strategy." Medium, 9 Nov. 2019, Accessed 5 Mar. 2022.

Lioudis, Nick. "The Importance of Diversification." Edited by Charles Potters. Investopedia, 29 Nov. 2021, Accessed 5 Mar. 2022.