Why Diversification is important in stock market investing

You must have heard about the common fundamental principle of investment “not putting all of your eggs in one basket” or “don’t put all your eggs in one basket”.  Which means don’t buy one or two stocks, instead buy a number of stocks of different companies from different industries. This is known as diversification.

Does it mean you will be investing in more than 100 stocks to get a well diversified portfolio?

If no, then what should you do? 

If you don’t know what diversification is, or how to make it work for your investment or how to manage risk and return, you are in the right place. 

In this article, we will tell you why diversification is so important in stock market investing.

What is diversification?

Diversification means, instead of investing in one company or in one industry, you invest in more than one stocks in different industries to balance risk and reward in your portfolio. 

It’s referred to as the key to minimising risk. 

You basically spread your risk across different types of stock which will react differently to the same market or economic event.

Diversification is not a new concept. American investor, Warren Buffett once said that “diversification is a protection against ignorance.”

The main purpose of diversification is to maximize returns by reducing some of the risk specific to a company or industry that can affect your investment. You also reduce the consequences of a wrong forecast.

In this way, when one type of stock in your portfolio goes down, another might go up, thus it reduces the chance of a radical loss of value of your overall portfolio.

The main objective is instead of relying on one stock or one industry, it’s better to consider a basket of stocks from different industries.

Why should you diversify

Stocks are generally more volatile than other types of investments. Diversification in stock investing is important because markets can be volatile and unpredictable.

Remember, the primary goal of diversification is not to maximize your return. Its primary goal is to balance the impact of risk and return on your portfolio

By investing your total funds in different stocks of several companies and sectors, you are reducing company related risk such as business and financial risk specific to a company.

It means, you are investing to avoid or minimize diversifiable risk.

Experts suggest that a portfolio of 15 to 20 different stocks spread across various industries can reduce all the company related risks for an individual investor.

Remember, diversification will not protect you from the market risk, which is also known as systematic risk. 

When the total market goes down, almost all stocks will go down irrespective of the sector or company. Even if you own more than 100 stocks of different companies from different industries, you are still exposed to the risk that almost all similar stocks will face during a bear market. This is known as market risk.

You can not avoid market risk. To reduce the market risk, you have to buy the right stock at the right price.

Investing in the same type of stocks of different companies is not diversification.

For instance if you are investing in different companies of Indian IT sectors, then it’s not diversification as you are putting all your money in one sector. You will not be able to protect your portfolio if anything affects the industry as stocks will behave the same way.

Similarly, if you are investing in one or all of the company’s stocks which are into the aviation sector, then you can not protect yourself in case of any adverse impact due to the market, economy and/or government decisions or risk specific to that industry. 

Assume for a moment that airline pilots have decided to go for an indefinite strike against certain decisions of the management which is difficult to fulfill. Due to this, all flights will be cancelled, sales and earnings will be reduced, as a result stock price will drop. What happens if you have invested your entire capital in stocks of companies in the airline industry? You will notice sharp fall in share prices.

In this example, if you want to counterbalance the risk, then an adequate amount of your capital should be invested in stocks of different industries which will have no impact due to the risk associated with the airline industry.

Diversification also reduces the impact of corporate fraud and bad information on your portfolio.

By diversifying, you are making sure you don’t put all your eggs in one basket.

Here are the most important benefits of diversification;

  • It minimizes the risk of loss to your portfolio in a bad event.
  • Safeguard your portfolio against economic downturn and an adverse situation.
  • Reduces the impact of market volatility.

Tips for diversification

Here are certain tips on diversification that may help you to built a solid portfolio of stocks by managing risk and return;

  • Before starting stock market investing and diversification, you need to set aside enough money in cash or in liquid assets to take care of 5-6 months living expenses and to handle emergencies.
  • Do not invest in too many stocks of one industry. For example, you should not invest only on IT sector stocks. You can keep 20% in the IT sector, 20% in banking and 20% in FMCG, 20% in infra and balance 20% in any other sector. This is just an example, not a rule to follow, you can change your own strategy as per your plan.
  • Make sure that you are not buying high beta stocks, as they are very volatile with the market movement. Check company fundamentals and buy the stock at the right valuation.
  • Based on your age and risk appetite, you can also consider to put 20% to 30% in government securities. You can change the percentage based on your risk appetite. You can also choose bond, real estate and other alternative investments.
  • Based on your risk taking capability, you can spread over large, medium and small companies in a variety of industries.
  • Try buying stocks of a company with a wide range of products and services.
  • Create your portfolio by investing in 15 to 20 good stocks you know, trust and even use in your day-to-day life.
  • Know your tolerance for risk and then build your investment portfolio accordingly. Focus on your long term investment goals and stick to a disciplined approach in stock investing.
  • Subtract your age from 100 and invest the resulting percentage in stock or mutual funds; the rest in risk free securities. For example, if you are 60 years old, then 40% you can invest in equity and 60% in risk free securities.

Some investors, rather than buying a single company or stocks from one or two industries, buy an entire stock index to get the diversification of owning stock in many companies of different industries.

To reduce volatility, some fund managers prefer international diversification. In which, they invest in different companies, industries of different countries.

Remember, diversification can help you manage risk and reduce volatility but risk can never be eliminated completely. 

You need to do your own research to choose the best stocks from different industries to have a satisfactory return by minimizing risk. 

Diversification ensures that you can achieve your long term goals while still getting a good night’s rest.

If you are a beginner, we suggest you invest in the stock market through mutual funds. Mutual funds are a group of stocks invested in different industries. By investing through mutual funds, your money invested will automatically be diversified to a certain degree. You can choose Systematic Investment Plans or SIP to invest a fixed amount at a regular interval regardless of market volatility.

is a fellow member of the Institute of Chartered Accountants of India. He lives in Bhubaneswar, India. He writes about personal finance, income tax, goods and services tax (GST), company law and other topics on finance. Follow him on facebook or instagram or twitter.