Known as “the only free
lunch in finance,” diversification
is the practice of reducing one’s investment
risk by adding more and more investments (stocks
i.e. companies) to one’s portfolio. Why is
so much importance given to diversification?
By only owning shares of one stock you essentially
have all your eggs in one basket. Let’s say
for instance you only hold shares of XYZ Company.
By holding this one company your entire portfolio
is subject to the performance of XYZ. If XYZ has
a good year, your portfolio has a good year, and
if XYZ has a bad year, your portfolio has a bad year.
Most importantly, if XYZ has an unexpected catastrophe
and is forced out of business (Enron, WorldCom, AIG,
Lehman Brothers, Fannie Mae, etc.) you lose 100%
of your entire portfolio. This is one event with
no recovery and is extremely detrimental.
Now let’s say you own two different stocks
equally, XYZ and ABC. With the addition of only one
company to the portfolio, your specific company risk
is significantly reduced. Now if XYZ has an unexpected
catastrophe and is forced out of business, all is
not lost and 50% of the portfolio’s assets
It is easy to see how owning many stocks can greatly
reduce an investor’s portfolio risk and can
be done to a point where any one company is such
a small portion of the total portfolio that it going
out of business has only minimal impact.