We should all be relatively familiar with the idea of diversification.
The concept is really pretty easy to illustrate: in order to reduce your risk of losing all your money overseas, you might have various sources of money with you; some in cash, some in the form of credit card and traveller’s cheque.
If not, my Mum has also once told me to separate my cash by putting them into different compartments of my travel bags and luggage.
So this, is a very simple way of diversification!
When it comes to investment, the concept is pretty much the same.
You have $30,000 worth of spare cash to invest. Do you put them all in one stock, a few stocks, or perhaps 50% in stocks, 30% in bonds and 20% in fixed deposits?
That’s diversification in action!
Here’s a few important things you need to know about diversification:
- Diversification reduces overall risk
- To achieve diversification, you need to choose assets with low correlations with one another
- Diversification is important because we have no way of predicting which investments will perform well or poorly.
The key is to determine what to use in your investment mix and in what percentages.
When it comes to diversification, you need to think about 2 ways of doing it – between asset categories and within asset classes.
So first, you need to split up your portfolio into investing in different asset classes (such as bonds, ETFs and stocks); in addition, you’ll also need to spread out your investments within each category.
An example would be to invest in stocks from different sectors.
This is because if you invest in asset classes in similar sectors, when that single industry is not doing well, your holdings will most likely be negatively affected.
To start, you need to make sure your investment mix is aligned with your investment time horizon, financial goals, and comfort with volatility. Usually, these are divided according to the 3 broad investor profiles:
- Conservative – more than 50% in bonds, 20% stocks, 30% short term investments
- Balanced – 40% bonds, 35% stocks, 25% short term investments
- Growth – 25% bonds, 50% stocks, 25% short term investments
You may also want to look at the historical coorelations of assets to help you in your diversification mix. Generally, look for asset classes that is 0.5 to negatively correlated.
To give you an example, traditionally, gold and stocks have had an inverse correlation.
And if you’ve been following the recent bad news in the stocks markets, you might also see that gold has been trending higher in recent weeks.
Do note that diversification is not a one-time task. Over the years, as market conditions change or perhaps your investor profile has changed as well, you’ll need to get on the rebalancing act.
The goal is to reset your investment mix to bring it back to the appropriate risk level for you. For instance, maybe as you get closer to retirement, you might want to increase your allocation in more conservative investments.
Remember that investing is an ongoing process so you’ll need to conduct regular checks to keep your portfolio on track!