The Diverse Definitions of Diversification

"Diversification remains one of the most fundamental investing principles, and it’s often one of the most misunderstood," says Carl Richards, a writer for The New York Times whose primary focus is the stock market. Investors typically view stocks as individual entities instead of groupings or as a collective whole. We often neglect how individual stocks work in correlation with one another for the benefit of the whole and instead focus on which individual stock potentially offers the greatest return in the shortest duration of time. This approach to investing is short-sighted. Putting all of your eggs in one basket is a considerable risk, but spreading around your money allows one to reduce certain risks that come with placing your money in the stock market.

A diverse portfolio is one that is spread out in a variety of markets and not concentrated on a particular company or industry. This makes it less likely that you will be fully impacted if an entire industry were to crash; just ask those who put all of their investments behind the dot-com explosion in 2001. The same is true with purchasing individual stocks. Yes, placing a large sum of your investments in an individual stock can lead to a large return, especially if you pick the next Apple or Microsoft. However, the odds are highly improbable and if the company collapses, so does your portfolio.

The volatility of the market over the past 10 years has led many to believe that diversification is irrelevant. The current standing of the global economy is less than stellar, meaning all stocks are subject to another recession. So yes, one can say that diversification is irrelevant if the entire market crashes. But rather than saying diversification is irrelevant, for those who would like to remain secure, maybe the definition of the term simply needs to be altered. Dividing your investments between stocks and bonds is a safe way to potentially acquire a return on your investment while reducing the level of risk. The New York Times examined two portfolios over the past 30 years. One solely invested in the S&P 500 (domestic stocks) and the other diversified with 60 percent invested in stocks and 40 percent in bonds. Although the non-diversified stock had a 1 percent higher return rate, it also experienced 7 more quarters of negative growth. So yes, with another recession potentially looming, the old definition of diversification may not save you from a precipitous crash, but spreading your wealth between risky stocks and safe bonds may save you some money as well as frustration.

This guest blog was written by PRowl Public Relations staff member Evan Galusha.