The Importance of Diversification


Diversification is a key element of any investment strategy. By putting your investment dollars in a variety of assets, you can limit the risk of significant losses, reduce volatility in your portfolio, and take advantage of a wider array of opportunities, potentially boosting your long-term returns. For startup employees receiving equity compensation, however, diversification can be challenging. In this article, we’ll discuss why diversification is important as well as some ways startup employees may be able to reduce their concentrated positions in their employers’ stock to diversify their portfolios.

What is diversification?

Generally speaking, diversification simply refers to holding a variety of different types of investments rather than putting all your eggs in one basket, so to speak. Often, we think of diversification as spreading investments across different asset classes, such as stocks, bonds, cash and cash equivalents, and real property like commodities or real estate. However, it’s also useful to think about diversifying across industries, market sectors, locations (for example, holding US, foreign, and global investments), market cap (which refers to company size), and style (i.e., growth vs. value stocks). By creating many types of diversity in your investment portfolio, you can more effectively mitigate risk and take advantage of gains in all segments of the market.


Diversification Across Asset Classes

Diversifying across asset classes can lend stability to an investment portfolio by blending assets whose values don’t strongly correlate with each other. For example, stocks tend to perform well during times of economic expansion, while bonds tend to be weaker, and cash may lose value more quickly due to an uptick in inflation. By spreading your investments across these classes, you may be able to limit losses and continue to see some gains throughout various market conditions.


Diversification Within Asset Classes

It’s also important to diversify your investments within each class of assets that you own. A well balanced stock portfolio, for example, would include stocks in large, medium, and small companies, in U.S. and foreign companies, and in a variety of industries and market sectors (e.g., energy, IT, healthcare, and consumer staples). As with diversification across asset classes, it’s wise to select investments within each class that perform differently from each other over time and across different economic environments.


Advantages of Diversification

Holding a diverse collection of investments is the simplest way to control your risk of loss while enhancing your portfolio’s potential for long-term growth. In the short term, some investments will do well while others underperform; as market conditions change, yesterday’s losers may be tomorrow’s winners. By spreading out your investments, you can take advantage of opportunities that different economic climates provide without risking intolerable losses.


Lessons from Recent History

Looking just a few years back to market performance during the COVID pandemic provides a powerful illustration of the importance of diversification. In the wake of the sudden, dramatic, and unforeseeable shift in consumer behavior that the pandemic necessitated, companies in the energy sector struggled as people stayed home more and the demand for oil plummeted. On the other hand, technology companies experienced a boom as they supported the massive number of people working from home, as did communication service companies, which provided much needed entertainment via streaming services and social media.

Diversification within sectors was also an important part of maintaining portfolio health through the pandemic. Companies in the consumer discretionary sector like retail stores and restaurants varied in their performance, as consumers flocked to those that were already selling products online and may have been unable to purchase from those who relied on brick-and-mortar locations. With these examples, it’s easy to see how spreading investments across a wide variety of sectors, industries, and types of companies provided valuable protection from some of the considerable losses that accompanied the global pandemic.


Factors to Consider when Diversifying

Appropriate diversification looks different for different investors. Two important factors to consider are your time horizon and your risk tolerance. Time horizon refers to the length of time you intend to hold an investment before selling it, and risk tolerance describes the degree of uncertainty about an asset’s performance that you’re willing to accept.

The longer you plan to keep your money invested, the more time you have to make up for short-term losses, ameliorating the risk of investing in volatile assets that have potential for large gains over time. If you anticipate needing to liquidate your investments soon, however, more volatile investments create added risk, as a market downturn could put you in the position of needing to sell while prices are low.

Individual risk tolerance adds another layer to this calculation. Even if you’re a young professional who is decades away from retirement and not planning any large expenditures in the near future, substantial short-term losses could be very distressing. Your comfort with riding market ups and downs is an important factor in deciding on the right asset mix.


Overcoming Barriers to Diversification for Startup Employees

When you’re working for a startup and receiving equity compensation, it’s easy to accumulate a highly concentrated position in your employer’s company. This can create a large amount of risk that may not be easy to mitigate, as your equity could lack liquidity for a variety of reasons, such as the following:

Depending on the type of equity compensation you’ve received and your company’s policies, however, there are a few ways you may be able to sell some of your position and diversify your holdings.

  • Some companies take steps to generate liquidity for their employees. They may do this by setting up internal trading networks, organizing stock buybacks or tender offers, or allowing employees to trade pre-IPO shares on secondary markets.
  • A margin loan could allow you to borrow against your shares. Be aware, however, than if the share price subsequently falls, you may be on the hook to provide additional collateral.
  • You could generate liquidity via a prepaid variable forward (PVF) contract. In this arrangement, a third party agrees to purchase the stock at a price that will be determined based on its future performance but pays you a large portion of the shares’ value upfront. Because you agree to transfer the shares at a specified time in the future, it is not considered a finalized sale at the time you receive the funds.
  • If you have unvested stock options or shares, you may be able to exercise them early. The details of your stock option agreement will determine whether this is allowed. If so, you could realize substantial tax savings by filing an 83(b) election within 30 days of the exercise date. Learn more about this process by reading our article, “What Is the Benefit of an 83(b) Election?

You may have multiple liquidity options available to you. To fully understand your choices and the benefits and drawbacks of each, it’s important to consult with a reputable investment advisor who has experience working with startup employees.


Expert Diversification Advice for Startup Professionals

You can avoid exposing yourself to certain losses by ensuring your investment portfolio is properly diversified. Bear in mind however, that diversification is not a guarantee against market losses. If you have a highly concentrated position in your startup company, the experts at WRP can help you explore potential avenues for gaining liquidity. We specialize in working with employees and executives of pre-IPO companies to make the most of the opportunities that their equity compensation provides. Learn about our individualized approach to wealth management, or explore our blog for more financial tips and insights.

DISCLAIMER: This article is for informational purposes only and does not constitute investment advice. This article contains information of a general nature and does not address the circumstances of any particular individual or entity.