What is Diversification?
If you’re a regular reader of any other source of financial education, you’ll have come across the word “diversification” a lot of times. But what does it actually mean, and why is it beneficial? We’ll spend a little time thinking about this in this article!
Ever heard the saying “don’t put all your eggs in one basket”? This is effectively what we mean by diversification in general life, and it also applies in an analogous way when we think about investing.
Diversification is a way for us as investors to manage the amount of risk we take, minimizing unnecessary risks while maximizing the potential return we can get for taking such risks.
Without going into the mathematics behind why this works, the idea is to spread your investments (or “eggs”) across lots of different “baskets” to avoid being too exposed to any one “basket” in particular.
In the investing sense, these “baskets” can be any financial instruments with differing characteristics: each basket should be inherently different from the next.
In practice, this means you might want to have a range of investments (or eggs!) in many different “baskets”. Some examples include:
» You could spread your investments across different assets classes such as stocks, bonds, real estate, private equity and so on.
» If one of these asset classes performs poorly, you are relatively shielded if you aren’t fully invested in that one asset class which struggles.
As a very simplistic example – if there is a slowdown in economic growth where stock indices lose around 20% in value while bonds lose 5% – you would do better if you were holding a portfolio consisting of 50% stocks and 50% bonds versus being invested fully in stocks.
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» You could also spread your investments across different countries. This was previously difficult to do but is now becoming much easier!
» If you are invested across multiple geographies, you may do well even if investments in your home country doesn’t do very well.
» Being invested in multiple different countries also limits your exposure to any one particular country doing badly.
» Note: Exchange rates matter here, so it’s worth bearing in mind that investing outside of your home currency market could either add to or take away from your total investment return depending on whether your home currency performs strongly or poorly versus the foreign currency.
That said, if you have diversified your investments across multiple currencies, the impact of foreign exchange movements should be relatively limited.
» The FAANGs, Tesla and other tech stocks may arguably be great investments, but is it wise to invest all of your hard earned savings into just this handful of companies? If you don’t feel too comfortable about that idea, perhaps you’d be well served to consider investing in companies across a variety of industries such as finance, healthcare, retail, etc!
» Diversifying your investments across various “industry” baskets could help you to minimize your exposure to any one particular industry.
Downsides to diversifying: Time / cost and potentially limited gains in the short run
We get it – diversifying can be a pain if you have to do the research on many different stocks, let alone asset classes or across different countries. But there’s a solution to that: investment funds.
Many investment funds offer you exposure to a mix of investments which are already diversified by the fund manager, so you don’t have to do all the hard work yourself – they do come with a management fee and costs, but these costs are likely to be lower for you than if you were to buy lots of different financial instruments and manage the investments yourself.
If you still don’t like the idea of paying someone to actively manage your portfolio for you, there is another way – you can build your own diversified portfolio by investing in a variety of ETFs, which do have a cost associated with investing in them, but a cost which is relatively small compared to actively managed funds.
Even if you take out the time consuming aspect of diversifying your portfolio by investing in funds as mentioned above, another thing to consider is the fact that diversification limits your losses, but it can also limit your gains (in the stock market example above, if the stock market gained 20% while the bond market gained 5%, you would obviously have been better off being fully invested in stocks).
Of course, this is something to bear in mind when diversifying your portfolio – are the potential risks and rewards involved in your particular portfolio diversified just enough for you to be comfortable with the risks while remaining sufficiently exposed to the potential rewards?
Finally, all of the above may seem like common sense to you (if it does – well done – you’re thinking with the right mindset!), but when looking at your investment portfolio overall we would encourage you to ask yourself something along the lines of the following:
Am I happy with the level of diversification in my portfolio, or do I need to consider adjusting the amount of risk I’m taking across more, or less, “baskets”?
A simple question, but one that we hope can help guide you towards achieving a healthy balance for your investments! :))
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