| Do not put all your eggs in one basket is an idiomatic phrase, meaning that one should not focus all his or her resources on one hope, possibility or avenue of success. If you put all your eggs in one basket, you risk everything on a single opportunity which, like eggs breaking, could go wrong. |
In Finance, this problem is alleviated through diversification. Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries and other categories. It aims to maximise return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimising risk. Here, we look at why this is true, and how to accomplish diversification in your portfolio.
Different Types of Risk
Investors confront two main types of risk when investing:
- Undiversifiable– Also known as ‘systematic’ or ‘market risk’, undiversifiable risk is associated with every company. Causes are things like inflation rates, exchange rates, political instability and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated, or reduced, through diversification; it is just a risk that investors must accept.
- Diversifiable– This risk is also known as ‘unsystematic risk’, and it is specific to a company, industry, market, economy or country; it can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so that they will not all be affected the same way by market events.
Why You Should Diversify
Let’s say you have a portfolio of only airline stocks. If it is publicly announced that airline pilots are going on an indefinite strike, and that all flights are cancelled – share prices of airline stocks will drop. Your portfolio will experience a noticeable drop in value. If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance that the railway stock prices would climb as passengers turn to trains as an alternative form of transportation.But you could diversify even further, because there are many risks that affect both rail and air since each is involved in transportation. An event that reduces any form of travel hurts both types of company – statisticians would say that rail and air stocks have a strong Therefore, to achieve superior diversification, you would want to diversify across the board; not only different types of companies, but also different types of industries. The more uncorrelated your stocks are, the better.
It’s also important that you diversify among different asset classes. Different assets – such as bonds and stocks – will not react in the same way to adverse events. A combination of asset classes will reduce your portfolio’s sensitivity to market swings. Generally, the bond and equity markets move in opposite directions; so, if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.
Some investors dismiss diversification, saying you’ll make the most money if you hold only the most lucrative asset. Obviously, that’s true. The trouble is you can’t be sure what that asset will be in advance, particular over the short-term. Also, the highest returning asset is usually the most-risky one; so the chances of loss are greater, too. There are also time-factors to consider when deciding what assets to hold.
Shares are the best performing asset over the long-term, but not always in the short term. A bear market in shares can savage your returns and your net worth. For this reason, even investors with a long investment horizon will often hold a portion of their portfolio in less volatile assets. There is no point putting all your savings into shares for a prosperous retirement, only for market gyrations to cause your hair to prematurely fall out!
Do remember a portfolio changes over time. As some assets do well while others do badly or simply hold their value, the inherent diversification of your portfolio will change.
A common example is an investor who puts 25% of their wealth into the stock market and sees it double over a few years. If nothing changes, they now have 40-50% of their wealth exposed to one asset class, instead of the 25% they were initially comfortable with.
Conclusion
Diversification can help an investor manage risk and reduce the volatility of an asset’s price movements. Remember, though, that no matter how diversified your portfolio is, risk can never be eliminated completely. You can reduce risk associated with individual stocks, but general market risks affect nearly every stock, so it is important to diversify also among different asset classes. The key is to find a medium between risk and return; this ensures that you achieve your financial goals while still getting a good night’s rest.
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Omega Capital Limited is an Investment management, private equity and investment advisory firm. The Company is authorised and regulated by the Securities and Exchange Commission of Ghana.
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Disclaimer
Additional information is available upon request. Information has been obtained from sources believed to be reliable but Omega Capital Limited (“Omega Capital” or “The Firm”) does not warrant its completeness, accuracy or veracity. The firm is licenced and regulated by the Securities and Exchange Commission of Ghana (SEC). This material is for information purposes only and it is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The opinions and estimates herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients. Periodic updates may be provided on companies/industries based on company specific developments or announcements, market conditions or any other publicly available information.
