When it comes to investing, we often hear professionals mention the term: Diversify – which simply means to spread your eggs (investments) across more baskets, therefore reducing the risk of any single crashing investment from destroying your entire wealth. While simple in principle, this may be confusing for many of us. Fret not, in this article, we will:
1) Break down the risks of overconcentrated investments
2) Explain how diversification may reduce these risks
3) Guide you on how to diversify your investments
Individual investments entail specific risks which can lead to huge losses during unpredictable events. Take for instance:
Such extreme crashes exists outside of cryptocurrency as well, and plagues all form of investments, including stocks and ETFs. Consider:
The risks are especially high for short term bets which could turn wrong very quickly. An overconcentrated investment may cost you your entire life savings.
Diversification is the predominant method which is used to reduce specific risks arising from individual investments. Diversification also reduces the volatility of your portfolio. To illustrate this:
Given 3 fictitious stocks, A, B, C, and their 1-year performance:
Holding Stock A only will yield a return of -30%. However, in a portfolio which holds each stock in equal proportion, the yield will be instead -15%.
This happens as the worst performer (Stock A) is partially offset by better performance in other stocks (Stock B & C).
Very often, we cannot predict with certainty that a single investment will perform as forecasted and it is more prudent to spread out our chances through diversification. This allows us to:
1) Reduce the impact of adverse events affecting any one of them on your portfolio
2) Reduces the risks of you from not having access to your funds when you need it
3) Improve your ability to tide through short term poor market conditions
When we diversify our portfolio, there are 3 broad categories to consider when picking out investments:
1) Asset Classes
a. Stocks
b. Bonds
c. Cash
d. Private Equity
e. Crypto Currency
2) Geographical Exposure (Not exhaustive)
a. USA
b. China
c. Asia Pacific
d. Latin America
e. Europe
3) Industries (Not exhaustive)
a. Technology
b. Real Estate
c. Retail Goods
d. Utilities
e. Financial Services
The key is to limit our exposure to any single category and aim to spread them out across investments with different exposures. The ideal proportion of each investment is largely dependent on your investment risk profile and investment timeline, which vary from person to person.
It is understandable that many of us simply do not have the time or knowledge to diversify on our own, and much less to monitor them on a daily basis. What you can however do is to:
Consider asset allocation funds (mutual funds) that are professionally managed and diversified across a wide range of products
Keep in mind that diversification seek to reduce our investment risks and does not guarantee superior returns. When in doubt, always speak to a professional to better understand the wide range of diversified options that will best suit your investment needs.
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