The importance of diversification

We all know the phrase of “not putting all of your eggs in the one basket” but when it comes to investing especially if an investor has not experienced poor investment returns in a while (or possibly, even ever) this approach gets consigned to the category of applying to other people only. If it’s the one thing that a lifetime of being involved in investments has taught me is that poor returns always follow good returns and the only way to gain a long-term position growth on your investments is to apply time, not timing to your monies. For time to work, the importance of diversification is key. But what exactly is diversification and how should you go about it?

Perhaps it might be easier to describe what it is not. Over the years I have come across portfolios spread across different investment houses but using the same type of fund approach , be it a managed fund or a consensus fund. Just because a different name is on the investment document does not confer diversification.

So how do you go about being diversified? First of all you need to divide your investments between a range of investment assets – equities, government and corporate bonds, property, cash and even some commodities including gold. This task is labelled Asset Allocation and is, by far, the most important investment decision you will make. Rather than focus on the specific investments, getting the broad mix right will determine the broad rate of investment return you will achieve, on average, over time. This will also determine the volatility of your overall portfolio. Portfolios with higher equity content, especially in the sector that is referred to as Emerging Markets, will be far more volatile than a portfolio with government bonds and cash.

The main focus on diversifying is to minimise, if possible, Correlation. Assets that are directly correlated will move up and down in broadly the same proportions all of the time. By diversifying, an investor is looking to own investments that move in different directions at different times. Overall you need some parts of your portfolio to move up while others are moving down. This is called “smoothing returns” and counters the “roller coster” of volatile markets.

In selecting specific assets you will need to direct your monies towards international shares and bonds since they often act slightly different than domestic investment assets due to the fact that the economies are apart. The same argument can also be made investing in small companies rather than large companies, value companies rather than growth companies, property and even commodities.

While you can make considerable money by being concentrated in specific investments instead of having a broad based portfolio, the fact remains that you can also lose it all. Indeed, many elderly people were depending on bank dividends for their old age. All this has now changed. The same question might be asked of many employees in the leading IT companies whose only wealth is the employment related shareholding they now own.

The real foundation in diversity is to be found around a personal financial plan and determining how much an investment return is required. By focusing on an investment return that is appropriate to your circumstances your asset allocation should reflect your goals. When you do this, you should only make changes when your goals change, not when the market does.

Review your investments on at least an annual basis to ensure that one asset class is not widely outperforming another. If it does, sell the relevant proportion in excess of the original allocation percentages and apply it to the other non performing or lower performing sectors. This is known as Rebalancing and is an integral part of smoothing out investment returns.

Finally, resist the temptation to make dramatic changes just because a particular investment type does not set the world on fire. Diversification is based on the principle of return to the mean. Over time, asset classes will perform but maybe just not today or this year!