Why diversification matters

Investing is about trying to look into the future and seeking to predict the evolution of a business.

That is why many compare gambling on sporting events to investing in equity markets. Both require spending capital based on a belief in future events.

The difference is that gambling is typically a zero-sum game, meaning there is a winner and loser, and it entails the complete loss or gain of one’s principal.  


Bounce Back

Investing is different, in my opinion, because you can own the asset and can generate income from it, while having the asset also lose or gain value at the same time.  

By owning it, unless it goes bankrupt, you will not have a complete loss. (The loss can be temporary, unless you sell the asset.)

All that said, one reason why financial professionals advocate for diversification is nobody knows how the future plays out.

Sleeper Cells

In my opinion, by having a diverse set of assets in a variety of industries, you may be able to minimize your risk of loss, provided the concentration of your capital is spread out.

As we have seen over the last few years, certain segments of the market can lie dormant for a few years, and then have a big run in a matter of weeks.  

The best example, in my view, of this is the banking sector, which prior to the November election sat like a flat beverage for ten years.  

Bank Stocks

Once Donald Trump became president elect, the shares of large banks had 20% to 30% gains in less than a week.  

The Federal Reserve recently raised interest rates by 25 basis points and signaled two more rate increases ahead this year.

Rising interest rates are manna from heaven for the banks as their net interest margins get wider and wider.
That’s why, in my opinion, portfolio diversification is key. You never know when the fortunes of an underperforming sector will suddenly bounce back.

Photo Credit: Annie Nguyen via Flickr Creative Commons