- Diversification involves constructing a portfolio with mixed asset classes and exposure to different industries
- Diversification doesn’t remove risk – it reduces it
- Your risk tolerance depends on the type of investor you are: Conservative, Balanced or Aggressive
A company is failing but you have had all your money sitting in that one basket, rooting for it to rocket sky high. It goes bankrupt and suddenly all your eggs that took years of saving up – poof! Gone. This is because the stock market constantly fluctuates, so risk is something you always have to consider. In order to reduce this risk, you need to know about diversification.
What Is Diversification?
Diversification is a strategy that reduces unsystematic risk by constructing a portfolio with a variety of asset classes and exposure to different industries (unsystematic risk is the risk associated to the specific company or industry). It is similar to having a healthy diet. You need a good balance of fruit, vegetables, and protein to maintain good nutrition and a strong immune system.
If one of your investments starts to drop, your other assets will not have as severe of a reaction, and may even respond in the opposite direction. Ensuring that your investments have low correlation is the first step to having a well-diversified portfolio. What this means is replacing some of your beef intake with another meat such as pork will not improve the variety of your diet.
How To Diversify
By allocating your assets across a range of classes in such a way that it suits your risk tolerance and financial situation. Assets can be divided into 4 main categories:
- Cash and fixed interest
- Direct and indirect property
- Domestic equities
- International equities
And this leads to critical decisions to be made:
- What asset classes will be considered for selection?
- What percentages will be allocated to each class?
The stock market is an extremely volatile environment so holding cash and government bonds, which are extremely stable and liquid, is an excellent way to ensure you have reserves in the case of an emergency. As you determine your optimal mix of assets, ask yourself the following question:
What Type Of Investor Are You?
As previously mentioned, risk tolerance is a measure of an individual’s willingness to accept a level of investment risk in exchange for higher potential returns. The 3 most common risk profiles are as follows:
- Conservative investors are willing to accept a measured amount of risk to gain slightly longer-term returns. They do not expect negative returns. Portfolio: 80% defensive assets (cash and fixed interest), 20% growth assets (shares and property).
- Balanced investors seek a higher level of growth and perhaps some tax-effective returns from their portfolio, but they wish to have their growth assets ‘balanced’ by some defensive assets in order to manage the risk of their total portfolio. They are willing to accept some short-term risk in order to achieve higher medium to longer-term returns. Portfolio: 40% defensive assets, 60% growth assets.
- Aggressive investors are generally very experienced in investment markets and are willing to take a high level of risk in the short term when seeking high levels of long-term returns. They tend to be fully invested in growth assets and may have significant holdings in what are speculative investments. Portfolio: 20% defensive assets, 80% growth assets.
Therefore, your appetite for risk will influence your optimal asset allocation. Those who are sensitive to risk may tend to hold more cash whilst individuals who take on more risks tend to hold more stocks.
At the end of the day, diversification cannot eliminate risk – it only reduces it. There is no one true model that can suit every investor in the world because everyone’s risk tolerance, goals and financial situations are unique. However, an effective allocation of assets that can reflect your personal needs is seen as one of the most powerful diversification methods and provides that quintessential balance of risk and return.