Imagine you saved up £100 and put every single penny into a company called Blockbuster. They were the biggest video rental chain in the world, with thousands of shops everywhere.
Then Netflix came along, and suddenly, nobody wanted to rent physical videos anymore. Blockbuster went bankrupt, and if all your money was there, it would be gone forever. This is why you need diversification, the single most important rule in investing.
Most people have heard the old saying: "Don't put all your eggs in one basket." It sounds like something a farmer would say, and it is! If you carry ten eggs in one basket and trip on a rock, you probably won't have any eggs left for breakfast.
Imagine you are at a buffet. If you fill your entire plate with nothing but spicy chicken, and then you realize the chicken is too hot to eat, you have no dinner! But if you take a little bit of pasta, some salad, a slice of pizza, and one piece of chicken, you are guaranteed to have a good meal no matter what.
In the world of money, those eggs are your savings. The basket is the company or the place where you choose to put that money. Diversification is the strategy of using many different baskets so that one clumsy trip doesn't ruin everything.
Finn says:
"So if I buy shares in Apple, Disney, and LEGO, am I diversified? Or do I need like a hundred of them?"
The Blockbuster Lesson
When a company goes bankrupt, it means they have run out of money and usually have to close down. For decades, companies like Blockbuster and Toys 'R' Us seemed like they would last forever. They were giants that everyone knew and shopped at.
But the world changes fast. New inventions, like streaming movies or online shopping, can make huge companies disappear almost overnight. If you only own stocks in one company, you are betting everything on that one business staying successful.
The only investors who shouldn't diversify are those who are right 100% of the time.
Doing the Math of Safety
Let’s look at how the numbers work. Imagine you have £100 to invest. You have two choices for how to use it. You can put it all into one company, or you can spread it out.
Scenario A: 1 Stock Invest £100 in 1 company. Company goes bankrupt: You have £0. Loss: 100% Scenario B: 10 Stocks Invest £10 each in 10 companies. 1 company goes bankrupt: You have £90. Loss: 10%
If you choose ten companies and one of them fails completely, you still have £90 left. That is a small bump in the road. But if you only chose that one company, you now have £0. That is a total disaster.
The Four Ways to Diversify
Becoming a master of diversification means looking at your money from different angles. It isn't just about owning different companies. It is about making sure those companies aren't all doing the same thing.
- Across Industries: Don't just buy gaming companies. If the gaming industry has a bad year, you want to own some food companies or clothing companies too.
- Across Countries: Different parts of the world grow at different speeds. You might own some companies in the UK, some in the USA, and some in Japan.
- Across Sizes: You can own huge, famous companies and smaller, newer ones that might grow faster.
- Across Asset Types: This means owning different kinds of things, like stocks, or even just keeping some cash in a savings account.
Mira says:
"It's like having a backup for your backup! If the toy shop closes, the pizza place is still making dough. Literally!"
The Instant Shortcut: Index Funds
Spreading your money across hundreds of companies sounds like a lot of work. If you had to buy each one individually, it would take forever! This is where index funds come in to save the day.
Some index funds allow you to own a tiny piece of the 500 biggest companies in the US all at once. That's like being a part-owner of Apple, Amazon, Microsoft, and Disney with just one single click!
An index fund is like a giant bucket that already contains tiny slices of hundreds or even thousands of different companies. When you buy one share of an index fund, you are automatically diversified. You can learn more about how these work on our index-funds page.
Diversification is the holy grail of investing.
The Tradeoff: Smoothing the Ride
There is one thing you should know about diversification. It doesn't just protect you from the bad times: it also changes how the good times feel. This is the risk-and-reward balance that every investor has to manage.
You can make a huge amount of money very fast if your one choice is a 'winner.' But you could also lose everything just as fast.
Your money grows more slowly and steadily. You won't get rich overnight, but you also won't wake up to find your savings are gone.
If you put all your money in one stock and it doubles in price, you are a hero! But if you have 100 stocks and one doubles, your total money only goes up a little bit. Diversification makes the journey less of a scary roller coaster and more of a steady climb.
Finn says:
"I get it. It's better to be a 'slow and steady' turtle than a rabbit who might trip and lose everything."
Starting Small
Even if you only have a small amount of pocket money to invest, you can still practice diversification. Many modern apps and accounts for kids allow you to buy tiny pieces of index funds for just a few pounds.
Diversification is protection against ignorance. It makes very little sense if you know what you are doing.
By starting early, you learn that the goal isn't to find the one "magic" company that will make you a billionaire. The goal is to build a strong, sturdy collection of investments that can survive any storm. That is how real wealth is built over time.
Look around your house. Can you find 5 different things made by 5 different companies? (Check your shoes, your cereal box, your tablet, and your toys). If you owned shares in all of them, you'd be diversified!
Something to Think About
If you could only pick three industries to own forever, which ones would they be?
Think about what people will always need. Food? Technology? Medicine? Entertainment? There are no wrong answers, but notice how picking three different things already makes you safer than picking just one!
Questions About Investing
Can you be 'too' diversified?
Does diversification guarantee I won't lose money?
Is keeping money in a piggy bank diversified?
Your Financial Safety Net
Diversification isn't about being lucky; it's about being prepared. By spreading your money around, you are making sure that you can handle whatever the future throws at you. Ready to see how you can own 500 companies at once? Head over to our page on index-funds to see the easiest way to diversify!
