Diversification 101

 The proverbial eggs in one basket.

The proverbial eggs in one basket.

What! $%&/*& is diversification? Why it is important?

Diversification is, in just a few words, a way to reduce the risk of loss. Of what? It depends on what you are diversifying.

Yes, diversification is something that can be applied in many fields, beyond investments. Here some examples:

  • You can diversify your sources of income: If you only depend on your salary, if something happens to you that you can not work or if you are dismissed from your company, having diversified sources of income can allow you to continue receiving some income regardless of whether you continue with your job or not.
  • You can diversify your wardrobe: If you have winter and summer clothes you will be prepared to get out of your home regardless of the weather.
  • You can diversify how get from point A to point B: If you have access to different means of transportation, you can use them to reach different destinations depending on the occasion. 

You get the point.

But then, how to diversify your investments? In different ways.

  • Instead of buying individual stocks, you can buy mutual funds. A mutual fund can invest in dozens (or even hundreds) of companies. The impact of one of them failing in your portfolio is less if it is one of hundreds instead of being the only company in which you invest.
  • Instead of buying mutual funds that invest only in large companies, you can also buy a fund that invests that in small companies. This is called "asset category diversification."
  • Instead of buying mutual funds that invest in companies from a single country, you can invest in funds that invest globally. This is called "geographic diversification".
  • Instead of buying in mutual funds that only invest in stocks, you can invest in other "asset classes": Bonds. Commodities. Alternative investments. Yes, it sounds complicated (and it can be). This is called "asset class diversification".

For example, the portfolios that I typically recommend to my clients are invested in more than ten thousand companies of all sizes in over 30 countries and, depending on the needs, with exposure to various asset classes. All this, of course, according to the level of risk that each client is willing, able and needs to take.

What is the benefit of diversifying your investments?

In short: Not everything goes up at the same time and not everything goes down at the same time. In the 2007 crisis, for example, most of the stocks in the United States (and in many other countries) had significant losses, but other asset classes, such as high-quality bonds, maintained their value or even increased their value. little, which served as a "cushion" to cushion losses.

How not to diversify?

Having two financial advisors is not diversification. 

One mistake I have seen on multiple occasions is the assumption that if one financial advisor invests half of your resources and another advisor invests the other half you are diversifying. No. That is not diversification. If you want to use two investment advisors (although I do not recommend it), both (or at least one) should know how the other is investing. Why? For four reasons: To ensure that you are properly diversified, to avoid unnecessary and excesive exposure to risk, to understand your total costs and to be able to (as much as possible) have an effective tax planning and withdrawal strategy from your portfolio. 

How do you know if your portfolio is properly diversified?

We have tools at my office to help our clients measure their diversification. A "behind a napkin" way of determining: If you have individual stocks you're probably underdiversified. If you see a lot of "things" in your portfolio, but are not sure what they even are, you're probably not properly diversified. 

Diversification is just one of the ingredients of a complete investment plan. It foes not guarantee (or insure) against losses, but it can help mitigate them. If you'd like to talk about this or would like to explore the benefits or becoming a client, please schedule your complimentary Discovery Call using this link: http://miguelgomez.link/discovery

Photo by Natalie Rhea Riggs on Unsplash