You must have heard of the eggs and basket theory; it goes something like: Don’t put all of your eggs in one basket. But seeing that most of us don’t collect our eggs and carry them in baskets, we’re going to stick that old saying in our epic phrase modernizing time machine (we bought it online) and give you something a little more relatable to help you understand what diversification means when it comes to investing, and why it’s important to help you manage risk.
Don’t save all your photos in one place
Remember the perfect selfie you took on that trip to Japan? You caught the best light as the sun was setting - priceless! But before you had a chance to get it up on IG, you dropped your phone in the pool and the photo, along with all your dreams of breaking the internet with your #NoFilter #PerfectSunset #Blessed snap, faded faster than a Valencia filter.
The above completely made-up scenario is an example of how it’s not a good idea to put all of the things you value into one place. If something goes wrong, you could risk losing everything. If that photo had been saved in the cloud or on multiple devices, you would have been able to recover the pic easily and all of those potential Likes. The same logic can be applied to how you go about investing in shares in your portfolio. The idea is that you have a variety of stocks to spread your risk.
Diversifying shares by industry
No share is the same as another and there are lots of ways to look at shares and how they differentiate from each other. Besides shares belonging to different companies, those companies also fit into different industry categories. For example, Alibaba would be considered to be in the Retail sector, while Verizon is in the Mobile Telecommunications industry and Visa fits in under Finance. Owning shares in a few different sectors is one way to diversify your portfolio.
Diversifying shares by type
In addition to sectors, stocks can also be looked at in terms of how they behave at a particular time. There are a lot of different factors that go into defining why a stock would be put in a particular category, but here are a few examples of what those categories could be:
Value: These are stocks that are priced lower than expected when compared to various values shown in the company's financial statements. These shares have the potential to perform better than their more expensive counterparts.
Momentum: This category describes stocks with an upward trend in price. Sure, stocks tend to fluctuate in price when you are looking at day-to-day charts and trends, however, there are shares that show a more linear trend in price when looking at medium to long-term price movements.
Quality: These are stocks that are the culmination of a sum of parts that make for good business. These include consistent stock asset growth, strong corporate governance, low debt, and stable earnings.
Dividend: These are the stocks of companies that pay dividends to investors, allowing them to earn extra income from time to time, or the opportunity to reinvest the dividends.
Diversifying by currency
The markets have feelings too. Well not quite, but they can be sensitive to political or economic events that happen in a particular country. Even a single tweet by the US president can move the US markets dramatically. So, another way of diversifying could be to have some of your investments in local shares, while having others offshore. This can be done by investing directly into US shares in dollars.