Diversification is investing’s only “free lunch.” This phrase was coined by Nobel Prize winner Harry Markowitz who in the 1950s developed a formula for the “best” portfolio mix.
Diversification means building an investment portfolio that is made up of many different types of investments that behave in different ways.
Who doesn’t like a free lunch?
Firstly we need to understand the correlation between different investments. A high correlation means your investments may be impacted similarly by a specific event or change in the market. It can be great if it is a positive impact, but the other side is an event that negatively impacts your entire, closely correlated investment portfolio. For example, shares in oil companies might fall when oil prices start to drop; however, shares in the transport industry might jump up as profits increase from lower oil prices. By managing and spreading risk, it reduces your exposure to the risk of any single one of your investments providing disappointing returns. Even better, when performed correctly, it reduces your risk without decreasing your expected returns. Or in contrast, you can increase your expected returns without increasing your risk and making it a free lunch.
The different ways you can diversify:
1. Asset class
Different types of investments are structured differently resulting in different returns. Some examples are shares, bonds, property, commodities such as gold and alternative investments such as cryptocurrencies, crowdfunding and collectables like fine art or wine.
When you are looking at pension fund providers, you will see for different funds (i.e. conservative and growth) they have different allocations in types of investments. Diversification works because these assets react differently to the same economic event. For example, when there is a recession the economy slows, so investors become more interested in protecting their holdings and are willing to accept lower returns for that reduction in risk. Bonds and other fixed-income securities do well, and stocks as a whole tend not to do as well.
2. Number of investments
Whether you hold one investment or a lot of investments, you can find ways to diversify. Mutual funds or index funds provide investors with broad diversification with just one investment as they track a basket of stocks, bonds, or other asset class. By investing in an index such as the S&P500 which is US 500 biggest stocks, you are investing a little bit of money in each company that makes up the index. These will be companies from a range of industries and regions, so if one stock goes down, it is likely to be held up by the other companies in the index.
3. Geography:
Investing a portion of your money in different regions or parts of the world diversifies your portfolio because if one economy goes down, the returns from the other geographical location can take the sting out of any losses. An example would be investing in two different types of indexes in different areas - S&P 500 (US) and FTSE 100 (UK).
4. Industry/sector
By investing your money in different sectors, you’re reducing the risk of significant changes in one specific industry (e.g. the healthcare or automation and robotics sector). This has been highlighted earlier in the article using the price of oil and how it can impact a company differently.
How much should you invest in each asset class?
It is different for each investor as it depends on a lot of things – your risk profile, where you are in life and your financial goals. You can take the ‘What type of investor are you?’ quiz as a starting point for further research.
Overall, you cannot predict returns, but you can predict and manage risk, which makes a diversified portfolio your best defence against a financial recession.
According to portfolio managers, the optimal diversification is an investment in five to ten funds across varying markets or holding 20-30 stocks. The best way to see if your investments are diversified is to think of some different scenarios, i.e. if there was a decline in the price of oil? The overall decline in the price of shares? And to see how this would impact your portfolio. If the trend of your investments is leaning towards one answer, consider taking some steps to balance things out.
Information provided by goBuoyant is general in nature and does not take into consideration your personal financial situation. It is for educational purposes only and does not constitute formal financial advice. Remember, the value of any investment can go down as well as up.
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