Investment diversification: Why does it matter?
According to Investopedia, diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
The popular saying goes “Don’t put all your eggs in one basket”. This is true of investments as is true of everything else in life. Economist Harry Markotwitz popularised this approach to investing in the 1950s-60s, with his Nobel Peace prize-winning theory that investors should construct portfolios based on various risk categories.
What are the types of investment diversification?
There are broadly 5 different styles of diversification possible across various dimensions of investing.
- Diversification across companies: Betting all your money on a single company is not a good idea, even if it’s your own! With access to ETFs, LICS, managed funds or even a crypto ETF, it’s become extremely easy to access and purchase these instruments.
- Diversification across industries: Different industries have their own peaks, demands and troughs. Investors tend to build a local visibility approach to their portfolio. For example, investors in Western Australia might develop a bias for mining companies, and those in Sydney might have a bias towards financial services.
- Diversification across asset classes – shares, bonds, deposits, real estate, crypto, FX: Preferences for particular types of investments are personal choices. But looking at it rationally, it’s important to understand the performance of the underlying components. Many media and armchair commentators would make you believe that one particular type of asset class is a silver bullet. A lot of these ‘investment trends’ are driven by media hype cycles. It’s important to undertake a fundamental analysis of any investment with the aim to understand risks and rewards. There are always fringe investments that make headlines one way or another. The general rule should be that if something looks too good to be true, it usually is.
- Diversification across geographies – markets, countries: Although global markets seem to be increasingly correlated and take cues from each other, there are huge benefits to be able to access other markets. This is the trend driving investors from smaller markets such as Australia and New Zealand, which represent a mere 2% of global equities, to invest the global markets – through ETFs and other instruments.
- Diversification through time: When you buy parcels of investments over time, it averages out the cost of bad timing. Dollar cost averaging (DCA) is a strategy some investors use to reduce risk. It involves investing the same amount of money in a particular investment during regular time intervals. For example, buying $1,000 worth of Apple (NASDAQ:AAPL) shares on the first of each month. With dollar cost averaging, you purchase more shares when the price is low and less when the price is high. This essentially takes away the emotional aspect of investing because you are less concerned about market fluctuations. Read this blog post by my colleague, Emily, on the difference in outcomes and results she achieved.
What are the arguments against diversification?
In life, we are often told that “focus” or concentration is important. Are there people who have put all their eggs in one basket and made it big? Absolutely! You read about the rags-to-riches property and crypto billionaires and you might be tempted to think that ‘picking the right horse’ is the way to go about it. But, as it sounds, it’s like gambling – where you can only pick one winner. Access to diversified ETFs and even geographical diversification is really easy now. So, why wouldn’t you do it?
How do you track investment diversification?
You could set up a spreadsheet with all your holdings and add their current values into columns and then chart the values to visualise the diversity of your portfolio. This would involve either constantly updating the spreadsheet with the latest prices of the assets, or building an API to connect with various information providers – such as stock exchanges, share registries and online brokers.
As a user of Sharesight, I get to visualise my portfolio and the diversity of my holdings using the Diversity Report. It provides a visual breakdown of your portfolio by various default groupings such as Market, Sector, Investment Type, Country, as well as any Custom Groups you’ve set up:
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