The old adage that many of us have heard over the years of “Don’t put all of your eggs in one basket!” simply means diversification with regard to investing. So what exactly are the reasons that you should have a diversified investment portfolio?
Diversification means spreading your money in various different assets classes such as equities, property, bonds, and money markets. It also includes investing in international markets. But why is this important and does it still apply when these days most asset classes look to be such a basket case? Some reasons to diversify…
• Not all assets act in the same way and at the same time. Usually when shares are performing well bonds are not. There are times when this does not work but generally when interest rates are low shares are more popular. And we can see that gold has seen a rise in the current uncertain investment climate.
• Not all industries react to the same market conditions. In this instance think of two hypothetical companies. One is a winter investment selling rain umbrellas and the other sells sun screen lotion and tends to be a summer investment. During winter umbrellas sell well and during summer sun screen lotion is popular. Sales vary for each but if you were to put the two together you have the same average return and therefore reduce your risk.
• Investing in different geographical areas means you are not subject to the same natural disasters which will affect business differently. Take for example the recent Christchurch earthquake. Many businesses have struggled, having to close either due to damage of their premises or the effects of damage to the surrounding properties. Then again there will be a boom for builders in the months and years ahead as the city is rebuilt. There’s also the decline in property sales and values but those with undamaged investment property find their properties in demand as people look for rentals as their damaged homes are repaired.
• Investing all available money into finance companies was a bitter lesson for many New Zealanders who once saw these investments as a safe haven with a known rate of return. This was a lack of understanding of risk and unfortunately many placed all their funds in one company. Diversification within an asset class is also important to lower risk.
• During the Global financial crisis many moved away from equities and invested in cash. US Treasuries actually went up in the crisis showing that having them in your portfolio would have reduced your losses as they offset plunging markets. And who would have thought that some of the major US companies around before the crisis such as Citigroup would need bailing out.
While diversifying does not eliminate risk it does reduce your risk. Having a diversified investment portfolio still applies as a long-term strategy.