In the world of finance, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. This process is designed to help reduce the volatility of your portfolio over time.
The best investment managers in the world agree that, although there’s no guarantee you won’t experience negative returns at times, diversification is the most important factor in achieving long-term financial success while minimising risk.
Let’s look at a simple case study involving my hypothetical client named Ben:
- Ben is a 30-year-old Engineer looking for a stable long-term return on his investments.
- He has about $50,000 that he’s hoping to invest into the stock market.
- He also has a hot tip that the stock in Virgin Australia are about to skyrocket.
- Knowing that he probably shouldn’t put all his eggs in one basket Ben elects to invest $30,000 into Virgin Australia stocks and diversify his remaining $20,000 into Aurizon.
Has Ben successfully diversified his portfolio?
- Ben has chosen 2 stocks to invest his money.
- Both stocks are in the transport industry, because of this both stock picks are affected by many of the same risks.
- Portfolio analysts would say that air and rail stocks have a very strong correlation. This means that there is a strong likelihood that the two assets would move in sync (i.e. moving up and down at the same time).
- Ben would have achieved more diversification if he invested across the board, not only different types of companies but also different types of industries.
How would financial planners look at Ben’s portfolio?
- In the world of financial planning we look towards the correlation of assets.
- The more negatively correlated Ben’s stocks are, the better.
- It’s also important that Ben diversifies among different asset classes.
- Different asset classes are unlikely to perform the same over longer periods of time therefore, a good mix of asset classes will reduce the sensitivity of Ben’s portfolio to market swings.
Ben’s Bottom Line
Firstly, $50,000 isn’t a small amount. Ben could choose to further diversify his funds across different sectors and asset classes. Diversification could help Ben manage risk and reduce the volatility of his portfolio.
Ben can reduce his risk associated with individual stocks, general market risks however affect nearly every stock, and so it is also important to diversify among different asset classes.
Unfortunately, most people don’t have time to manage these risks themselves, so I would encourage anybody starting out investing to seek professional advice on the matter. The benefits of the advice would likely far out-weigh the costs.