If you’re an investor, diversification is a topic that’s impossible to avoid.
Diversification is one of the cornerstones of traditional investment advice. You may have heard of the statement, don’t carry all your eggs in one basket. The investment term to describe carrying your eggs in many baskets is portfolio diversification. In investment and indeed in all walks of life, that statement is self-evident because markets go up and down, economies move through different cycles, and a wide variety of factors changes investment outcomes.
If there is any rule in investment that needs to be religiously adhered to, it is “Diversify your investments”. Basically, diversification is a technique that reduces risk by allocating investments among various financial instruments, markets and other categories. So, how should you diversify your portfolio.
Portfolio diversification comes in many ways. One of them is diversifying across asset classes, moving beyond stocks and bonds, the traditional financial assets, to investing in alternative types such as real estate, derivatives private equity.
Diversification across different markets. Most investors have a bias towards instruments issued in their home country. But it is always beneficial to look beyond your local markets because shocks in one market may not affect the other.
Diversification using unit trusts. Unit trusts are one of the easiest ways to achieve diversification as well as asset allocation without in depth knowledge of each asset class.
Diversification sounds like a truly viable option that every investment club should take advantage of? So, why are so many investment clubs not using diversification? Probably the only explanation is that they don’t understand the benefits. Here are some of the benefits of diversification.
A diversified portfolio minimizes the overall risk associated with the portfolio. Since investment is made across different asset classes and sectors, the overall impact of market volatility comes down. Owning investments across different funds ensures that industry-specific and enterprise-specific risks are low. Thus, it reduces risks and generates higher returns in the long run.
When your holdings are widely diversified, you can spread them out over widely divergent forms of assets, including stocks, bonds and real estate. Each of these assets exhibits different strengths and weakness in terms of risk and profitability. By investment clubs maintaining holdings in all of these areas it helps to create a stable portfolio that will increase in value over the long term.
Diversified portfolios offer better risk adjusted returns, when two portfolios yield the same returns, a diversified one will take lesser risk than a concentrated one. Hence, for better risk adjusted returns, its vital for clubs to have a diversified portfolio across asset classes.
Diversification is a practical approach that every investment club should take advantage of. It allows investors to shuffle their investments and take advantage of the market movement. It lets investors spread their investment across different asset classes and increase annual returns.
Not every investment club is ready to play a risky game. Investment clubs that have just started investing prefer stability in their portfolio and diversification ensures the protection of their savings hence capital preservation.
Because assets perform differently in different economic times, diversification smoothens your returns. For example, while stocks might be underperforming, bonds and real estate may keep steadily growing.
Diversification combined with asset allocation helps you set and achieve your club’s financial goals. You base your asset allocation within your diversified portfolio on the length of time you need to realize a financial goal and your ability to tolerate risk.
Diversifying your stock portfolio is important because it keeps any part of your investment assets from being too heavily weighted towards one industry or sector.
Finally, diversification is a long-term strategy, and it should be treated as such. The common mistake that investors make is abandoning the strategy rather than sticking with it. Although having a diversified portfolio won’t eliminate all the risk, a well thought out diversification strategy can reduce risk.
There is no magical formula to building and preserving wealth rather, it requires patience, discipline and a sound portfolio strategy.
Hassan Kitenda CAIA, is an equity and fixed income research analyst.
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