Diversification

Diversification is aiming to broaden the types of investments you are holding to capture gains in differing areas of markets, while lowering your risk exposure due to concentration on a single, highly correlated investment.

Generally, diversification is discussed in 4 major parts, US equities (comprised of small, medium, large cap businesses, value & growth classifications), International Equities (same categorizations as US, just international businesses), US Bonds (municipal bonds, government bonds, corporate bonds, etc), and International bonds. These 4 types of assets are generally discussed in terms of diversification while discussing Asset allocation.

Beyond that, there are substantial subcategories of investments. Real estate, cryptocurrency, commodities (oil, precious metals, lumber, crops, etc), cash, cash equivalents (CDs for instance), collectibles (yeah, I’m looking at you, mom’s beanie babies…). If you own your home, for instance, then one of your largest portfolio asset classes is likely real estate in the form of a single home!

Let’s take a look at why diversification is important. Take Bitcoin, for example. People cashed out their life savings and invested in Bitcoin during the December run in 2017. It sky rocketed to over $19,000 a bitcoin. For an investor in BTC to have gotten in before $19,000 and sold at the peak, millions were to be made off the back of this run.

However, if you bought a single bitcoin any time in that December, you have never had an opportunity to sell it at a gain. Just one year later BTC was trading for $3,400 a coin.

In the same time period, the S&P 500 went from 2,600 points to 2400 points (tanked in December), DOW was roughly flat, median Seattle home price went from $741k to $770k according to Zillow, gold was up 5%, etc etc. You can see that there is some correlation in investments (i.e. US equities typically follow similar patterns, International is generally close to US equities, bond funds go up when equities go down, same with precious metals). However, by having exposure across a wide range of investments, and rebalancing when the concentration gets too high in one or the other, you’re able to weather some storms (like bitcoin, which is back up to $9,400, equities tanked this March but are back to mid March levels), and capture gains from faster growing markets (such as emerging markets).

More on this in Asset allocation about how to choose your portfolio.