Diversification Explained: Smart Money Move or Insurance for Investing Noobs?

Diversification Explained: Smart Money Move or Insurance for Investing Noobs?

Spreading your investments out lowers your risk, but it can also lower your rewards.

Aug 10, 2021

Diversification Explained: Smart Money Move or Insurance for Investing Noobs?
Robo Advisor

Robo Advisor

Stock Trading

Stock Trading

Long Term Growth

Long Term Growth

It's 2003, you're rocking a polo shirt with the collar popped, and you're headed to Blockbuster. You pull up to a suburban shopping center, neon blue and yellow lights shining down on you, and are greeted by that familiar scent of plastic cases when you walk in. It's the weekend, baby, and you're about to have a movie night.

You love this tradition so much that when your grandparents gift you $1,000, you use it to buy stock in Blockbuster at $20 a share. After all, everyone loves the wholesome thrill of picking out the scariest flick or cheesiest rom com on the shelves and pairing it with some sour candy or buttery movie theater popcorn. How could that ever die out?

Here's how that panned out:

  • In 2004, video rental alternatives like Netflix and Redbox start gaining popularity. You believe in Blockbuster and think they'll adapt, so you hold on. 
  • In 2007, Netflix launches a service called "Watch Now" that lets you stream movies from the comfort of your own home. The Blockbuster aisles start to empty out.
  • In 2010, Blockbuster's CEO claims in an interview that their financial troubles have nothing to do with Netflix. Their stock is now at 25 cents a share. You finally decide to sell, and you're left with $12.50—just enough for your first month's subscription to Netflix.

If you'd done your homework instead of listening to Blockbuster's overly optimistic CEO, you might've realized they weren't going to outrun the competition. But you don't really have the time to analyze the inner workings of every company to make sure it's a solid investment. That's where diversification comes in handy.

I've heard the term "diversification" 100 times, but what exactly does it mean?

Diversification is when you spread your cash out across a bunch of different (diversified) investments so that if one fails, you don't lose all your money. It's a risk-management strategy that's about never putting all your eggs in one basket.

So, instead of putting $1,000 into Blockbuster, you'd invest $100 into 10 different companies. If two or three tank but the rest do well, you'll likely see your investments grow. Blockbuster might have turned your $100 into $20, but if you had also invested $100 in Netflix, you'd have $25,000 today.

How do you diversify your investments?

Diversifying is about more than just buying lots of different stocks. As the name suggests, the stocks need to be diverse. If you invest in 10 different hospitality companies and people suddenly stop traveling (like they did during the coronavirus pandemic), your entire portfolio takes a hit.

In other words, if your investments are all correlated to each other—that is, they tend to move together or are related—they're not diverse enough to protect you against risk. You want to hold a basket of investments that mixes up the following features:

  • Industry
  • Sector
  • Company size
  • Country

You can do this by individually picking 10, 20, or 30 different stocks to invest in. Or, you can invest in products like index funds, mutual funds, and ETFs. These are essentially "baskets" filled with hundreds of different stocks, and when you buy shares of an index fund, mutual fund, or ETF, you invest in the entire "basket." This means you're automatically diversified.

That being said, all stocks are at least somewhat correlated. To really diversify your portfolio, you want to mix up the types of investments you hold. You can do this by adding alternative assets that aren't part of the stock market to your portfolio. This can include real estate, land, startups, collectibles, art, cryptocurrency, loans, and more.

Too much of a good thing?

You'll hear a lot of "I got rich off bitcoin" or "I built my empire on real estate" and never "I became a billionaire by investing in a reasonably stable basket of 500 different stocks." People diversify to protect their wealth, not to acquire wealth in the first place. Put simply: diversification lowers risk, but it also dilutes your returns. 

If you'd put your whole $1,000 in Netflix in 2003 instead of breaking it up across 10 companies, you'd have $250,000, not $25,000. But you would've had to have had the investing knowledge and foresight to be confident that Netflix would soar all the way back in 2003 to do that.

That's why Warren Buffett famously called diversification a "protection against ignorance." Then again, Warren Buffett telling you to confidently invest in one exceptional company if you want to get rich is a little like Channing Tatum telling you the key to scoring more dates is simply being confident. If you have the skills and knowledge to pick a sure winner then go all in—but most people can't do that.

The future of diversification

The degree to which you diversify is up for debate, but there's no question that you should diversify. Even Mark Cuban, who once boldly proclaimed that "diversification is for idiots," has built his wealth on a wide variety of different assets. Apart from stocks, he's invested in dozens of startups through Shark Tank and owns an NBA team, a film distribution company, and a TV channel.

In the age of information, when it's so much easier to find the details of a company and follow the latest trends, maybe the future of diversification is branching into different asset classes. Plus, alternative investing has never been more accessible.

It's still wise to contribute to your 401(k), but now you can also invest in other assets that help you diversify and have potential for better returns than a basket of stocks.
For example, apps like Groundfloor let you invest in real estate with just $10. Get a feel for real estate with smaller numbers first, and then work your way up to MTV Cribs.

groundfloor

GROUNDFLOOR

4.1

Real Estate

You can try your hand at striking crypto gold with apps like Coinbase that make it easy to buy, sell, and trade cryptocurrency from your phone. The volatility of crypto makes it a bad place to put your entire retirement savings but a great place to play with some extra money in hopes of hitting the jackpot.

coinbase

Coinbase

4.3

Crypto

You can easily diversify your portfolio with apps like Otis that let you invest in everything from art to iconic sneakers to rare comics. Otis lets you buy "shares" in collectibles like Michael Jordan's AJ1s the same way you'd buy shares in a company, and they start at just $10.

otis

Otis

4.3

Collectibles

True or False:

Diversifying your investments is the best way to get rich.

True or False:

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