What is investment diversification?
21 July 2014
One of the most basic things professional investors do is diversify. They generally call this asset diversification. In this context, "assets" are types of investments, such as shares, fixed interest investments (such as term deposits), bonds, property or alternative investments such as gold.
Why do they diversify? Because it is a way to spread the risk that something will go wrong. Take, for example, an equal diversification of 33% between shares, term deposits (cash) and property. The idea is that if one does badly, the others should compensate, at least to some extent.
Imagine that the shares fall. You would have made a loss. But then imagine if the property goes up by the same amount. Then you are back to where you started. And the term deposit may have gone up, say, 4%. Then at least you would be in front over the year, despite the shares declining in value.
Or imagine that the shares rise in value, but the property falls in value as much as the shares rise. Then you would still be in front because of the term deposit.
We can come up with many different scenarios. All three asset types in our example may rise in value, for instance. That would mean that the return will only be the average of all three.
The point is that it is less risky than if you, say, invested everything in shares or everything in property. If one asset type does badly, you can usually at least limit your losses, and hopefully compensate entirely, from the returns created by the other asset categories. It is unlikely that all three asset types in our example would all fall at the same time. In fact, in the case of term deposits it is certain that there will be a positive return.
These examples are of course very simple. But the principle is clear. If you diversify, you are less likely to have bad losses. Something you have invested in will do well, offsetting the losses you take elsewhere.
Equally, the rewards are also likely to be lower when you diversify. For example, if you put a portion of your portfolio in term deposits you will get a positive return, but it will not be as potentially high as if you put all your money in shares, where the returns can be much higher (and of course the losses much worse).
That is why the type of diversification depends on your attitude to risk and reward. If you have a large appetite for risk and are relatively young, then you may want to be more exposed to shares. If you are older and have a low tolerance for risk, you may want to be more exposed to low risk fixed interest.
There are many different ways to balance diversification within super. The right place to start is with the attitude towards risk and reward. Then the allocation of assets should be selected based on that risk/reward attitude.
Then there are all sorts of other diversication, such as picking different industries when buying shares. If one industry does badly, another may do well. Investors also try to pick assets that counterbalance each other. They might buy some bonds, for example, in the belief that they will go up when shares fall (this is called non-correlation). There is a lot of sophisticated theory in finance about diversification whose usefulness is questionable.
But it always is a good idea to diversify, at least to some extent. Just being exposed to one asset class usually means either high risk, or low reward.
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