The Importance of Diversification

The Importance of Diversification

Just as the most important thing in real estate investing is location selection, diversification is important when investing in stocks. Investors are well aware of the concept and importance of diversification. However, in reality, most investors do not diversify their investments without realizing it.

The biggest reason not to diversify is because of greed. This is because they secretly expect a jackpot in which the stocks they have chosen and invested in will rise significantly in a short period of time. It is similar to buying a lottery ticket and dreaming of being rich until the day of the announcement.

Along with the stock craze, there was constant news that he made a lot of money in an instant by investing in Tesla, GameStop, AMC, etc. as well as ARK Invest. As the saying goes, ‘How hungry is it when your cousin buys land’? Hearing the saga of making money by investing in stocks, I think that only I am missing out on a chance to hit the jackpot, so I decided to invest in stocks after thinking about it, so I don’t think about diversification at all.

It is difficult to hit the jackpot with diversification, but losses can be minimized in the stock market that is falling and plummeting. Let’s take a look at the current stock market situation. The stock market S&P 500 is down 9%, the Nasdaq is down 18%, and cryptocurrencies are down 40-60%.

What about the stock of any particular company? Shares of the world’s largest social media platform, Facebook’s metaplatform, fell 26%, the largest ever. In terms of market capitalization, a whopping 300 trillion won has disappeared. It accounts for nearly 75% of Samsung Electronics’ market cap. Imagine that Samsung, Korea’s leading company, has only 25% left overnight. Ark Innovation is down 50% from its peak. Shares of exercise equipment maker Peloton, which was at its peak due to the coronavirus, rose to $170 and then plummeted to $25. Netflix stock is also down 30% this year alone and is down 50% from its highs.

Stocks of 60% of the stock market are experiencing a 20% drop from their highs, stocks of 25% are experiencing a 40% drop from their peaks, and stocks of 15% are experiencing a whopping 60% drop from their peaks. If the stock I invested in was in the 15% range, the loss would be huge. For this reason, over the past three years, the stock market index recorded high returns with 27.9% in 2021, 18.4% in 2020, and 31.5% in 2019 investment, but investors who expected a jackpot are now regretting a painful investment loss.

The first step to investing properly is diversification, and the money you invest should be invested here and there. This is the investment portfolio composition referred to in the financial industry as ‘Modern Portfolio Theory’. In 1990, Harry Markowitz was awarded the Nobel Prize in Economics for this concept. The basis of this theory is how to construct a portfolio so that when investing, the risk is minimized while maximizing the return. In other words, it is a thesis that theoretically verified the unwritten rule ‘Do not put eggs in the same basket’.

The stock market is obviously constantly rising and falling, so you should diversify your investments by considering your investment purpose, age, risk, etc., rather than predicting the future. The reason I often refer to the S&P 500 is because it can recognize stock market changes and is representative of the stock market. However, investing in only one stock in the S&P 500 is risky.

During 2000-2002, the S&P 500 index fell to 14.6% due to the stock market decline, while U.S. Small-Cap Value Stocks rose 12.2%. During the 2008 financial crisis, stocks of big companies fell nearly 40%, while US long-term government bonds rose 26%. When investing in multiple stocks with the concept of diversification, you need to consider exactly which stocks are selected for what reason, what is the investment risk, and the investment risk of all selected investments.

Investors should diversify their investments to prepare for the stock market that may fall. This is because you can invest for a long time without giving up on your investment even in the stock market that is plummeting. This leads to a comfortable retirement life.

Myung-Duk Lee, Ph.D., Registered Investment Adviser (RIA)

Copyrighted, Dr. Myung-Duk Lee’s Financial Column All rights reserved.

MI Asian
Author: MI Asian