Last time we talked about whether or not diversification is a “good” thing. I said that you shouldn’t just go on auto-pilot, diversify the heck out of everything and then assume you’re going to be safe from risk. There are different types of diversification and you have to know what they are.
Read Part I: “Is Diversification A Good Thing?” here
Risk And Diversification
Before we go into those, let’s talk about risk. The whole point of diversification is to minimize risk but some risk is unavoidable. There are two types of risk – the type that you can steer clear of by diversifying, and the type that will get you no matter how you spread your stocks out.
For example, there could always be inflation, rising interest rates, market instability, wars, natural disasters and so on. These things affect every company in every sector of the economy.
The other type of risk affects one company, one industry, one sector, one type of asset, and so on. So, the purpose of diversifying is not only to spread your stocks out among different companies or different types of assets, but to spread it out everywhere so you’re covered in case of anything that can happen.
Two Broad Types Of Diversification
There are two broad categories of diversification – vertical diversification and horizontal diversification.
Vertical diversification means spreading your stocks out across different asset categories like stocks, bonds, mutual funds, cash equivalents, real estate and so on. There is a common misconception that this is simply what diversification means. Most people don’t realize the importance of horizontal diversification and that’s why their stocks fail.
Horizontal diversification means spreading your stocks out within an asset category. For example, within the category of bonds, you would invest in different companies or sectors. The idea is to choose those that will act differently under different market conditions. Doing so protects you no matter what the market does.
Beyond these two broad categories, there are also more specific types of diversification. You can diversify by investing in assets in different nations, for example. This protects you if the economy of one country collapses or domestic interest rates rise. This reduces volatility but it carries other risks of its own as well.
Another misconception that I’d like to mention here is that mutual funds are always diversified. This isn’t always the case. Your portfolio could easily be invested in only one sector or asset category, and this leaves you open for major types of risk.
We’re just scratching the surface here, but when talking about diversification, it’s essential to always keep in mind the goal – reducing risk. If you understand the many ways risk can occur, this will help you make the right decision when choosing stocks to invest in.