What Does it Mean to Diversify?

In the world of money and finances, you will often hear the term “diversify”.  The most common advice given by any financial adviser will boil down to one simple phrase:

 Diversify Your Portfolio

You have probably already heard a more common version of this phrase:

Never Put all Your Eggs in One Basket

If you have read our article on the basics of stocks, you may be interested in putting some money into the stock market.  Investing in the stock market comes with a level of risk that can be nerve wracking to those looking to make their very first investment.

Diversification is a common method of reducing the amount of risk that comes with investing.

Example

Let’s say I am looking to invest my hard-earned $100.00.  I am a fan of the company Jake’s Ice Cream, as they have recently opened a second branch and look to be a fast growing company.

I see that Jake’s Ice Cream is selling stock at $10.00 a share.  Based on my knowledge of Jake’s Ice Cream, I decide to use all of my money and purchase 10 shares of the company for $100.

The next day, after investing into Jake’s Ice Cream, a newspaper writes a groundbreaking article revealing that ice cream has a 75% chance of causing cancer.  This causes a large number of customers to stop going to Jake’s Ice Cream, and the value of the company goes down.

Each share of stock is now only worth $2.00.  This means that my $100.00 investment is now only worth $20.00. In only a day I have lost $80.00.  I am now probably feeling similarly to the following gentleman:

This loss could have been reduced if I had diversified my investment.  Rather than investing entirely in Jake’s Ice Cream, I could have only purchased a single share of the company.  The remaining $90.00 in my possession could have been invested in other companies unrelated to the ice cream industry.

Let’s say I purchased only 1 share of Jakes’s Ice Cream, and then I purchased 9 other shares of random companies outside of the ice cream industry, also valued at $10.00 each.

Now when the news article comes out and the value of a Jake’s Ice Cream share drops to $2.00, I have only lost $8.00 (assuming my other stocks kept their value).  One or more of my other stocks may have actually risen in value, possibly offsetting the $8.00 loss.

By diversifying, I have now prevented a tremendous loss of money.

If you are looking to start investing, never keep your eggs in one basket.

Diversify!