There are several ways to diversify your investments. The table below shows different ways you can do so.
Financial institutions, fund managers
Categories of diversification : Foreign currency
Two hypothetical examples of diversification
Here are two hypothetical examples to help you understand how you can diversify through stocks.
Hypothetical example 1 – An investment with and without diversification
Two pharmaceutical companies (A and B) are conducting extensive drug discovery research. The company that develops the drug first will generate a 20% return for investors, while the company that doesn't succeed will incur losses of 10%.
Let's assume that the two companies have an equal chance of developing the drug.
Peter and John each have $10,000 to invest.
Hypothetical example without diversification
Hypothetical example with diversification
Peter invests the entire $10,000 in Company A.
John prefers to invest $5,000 in Company A and $5,000 in Company B.
This hypothetical example shows how diversification can help you reduce the overall risk of your investments.
Hypothetical example 2 – Diversify for a higher return
Sam likes John’s proposed diversification, but feels that a 5% return won’t allow him to reach his objectives.
He thinks that Company A will discover the drug first. However, he’s willing to risk a drop in his investments on the chance that they’ll bounce back even higher. On the other hand, he’s not ready to risk all of his capital.
So, he splits up his $10,000 investment as follows:
He invests $6,667 in Company A and $3,333 in Company B.
- If Company A markets the drug first:
Sam makes 20% ($1,333) on his $6,667 investment but loses 10% on Company B ($333). That leaves him with a total profit of $1,000, or a 10% return.
- If Company B wins the race:
Sam loses 10% ($667) with Company A but makes 20% ($667) with Company B. So he doesn’t gain or lose.
With this hypothetical example, there's a 50% chance that Sam will make 10% on his investment, and a 50% chance that he’ll come out even.