Why Is Diversification Important?

Diversification is a word closely associated with investing, and its importance cannot be overstated right now. Diversification is the process of allocating resources amongst different security classes and categories in order to reduce exposure to risk – so that you, as the old saying goes, don’t put all your eggs in one basket.

Diversification is important when investing because no one has a crystal ball to know what asset class (i.e. large cap, small cap) or what asset category (stocks, bonds, real estate) will perform better than the others during a specific time period.

To understand how drastic the returns can be for different classes and categories, take a look at the 38% return spread between Small Cap Value vs. Large Cap Growth investments so far this year (through 8/18/20).

If your money is in Large Cap Growth investments, you probably feel pretty good about your 2020 returns right now. If you have a more diversified portfolio, you probably feel you’re underperforming right now. This is a good example of why diversification is so important. If you have all of your money in Small Cap Value investments, you’re down significantly this year because you don’t have exposure to some of the areas that are experiencing growth. On the flip side, if you have all of your money in Large Cap Growth investments, while they’re outperforming this year, that will not always be the case. 

Diversification should be viewed as a layering process. There are many ways to create diversification within your portfolio, including passive (index)/active, value/growth, domestic/international, stock/ETF/mutual fund, qualified/non-qualified, and a combination of investment strategies. For long-term investors, try to create flexibility in your portfolio for a varying investment market by deliberately layering diversification into your overall financial picture.