If you read the news or listen to the radio you will invariably hear investment professionals talking about how important it is to diversify. But what does this mean, why is this important and how do you do it?
We all know the old adage that one should not put all your eggs in one basket. Why? Because if you drop that basket, all the eggs break. That’s diversification.
Diversification is important because, at its core, it reduces risk. By spreading your investments, the chances of picking a dud or having your entire investment wiped out are significantly less.
A diversified portfolio is like having a whole team working for you on a tough task. If one part lags a bit, the rest can pick up the pace and over time the journey to the goal will be a smoother one.
While you have a much better chance of successful investing with the right process and skills on your side, the task remains laden with uncertainty – after all we are dealing with future returns – and the quality that a good diversification strategy brings should not be underestimated. So how should you do it?
Start with the world
Recent events have reminded us that even the most elite country’s “safe haven” status can be questioned, and that a good spread of currency and economic exposure is essential in building a robust long-term portfolio.
Limiting yourself geographically will heighten the sensitivity of your portfolio to knocks that affect a part of the world.
Be asset-class wise
Next, a major determinant of your future returns (and the volatility along the way), will be your asset allocation. The basic building blocks are equities, fixed income and cash, and you should aim for an optimum mix which will provide enough growth (equities in the long run) and enough stability and yield (cash and fixed income) to match your time horizon and needs.
Tactical changes may be useful from time to time, but a strategic long-term allocation goes a long way while it is left to do its work.
Tap into sectors
Within the equity portion of your portfolio, you should aim for a good spread of industries. If you only invest in gold or only invest in property, this can cause your concentration risk to go up significantly. This is where global investing comes into its own.
There are several growth industries that we are unable to invest in if we only invest locally.
Share specifics and credit partners
When it comes to equities, a minimum number of instruments and a maximum percentage per instrument will help to diversify away from share-specific risk. In the same vein, within the fixed income and cash portion there should be a spread of banks and instruments.
If you only own a handful of stocks, or are exposed to very few counter-parties, this will increase your risks.
Sticking with one capable manager for the long term can be a very good strategy. However, if the manager stays true to one style, it is likely that there will be periods where the approach works better than at other times.
Therefore it is useful to combine managers with different styles. For example, by combining a value manager with a momentum or growth manager, or a passive solution with an active manager, can mean that when a particular style is out of favour, your portfolio will not necessarily languish in the doldrums.
The process of building a well-diversified portfolio is best performed with a qualified and experienced financial adviser. The reality of investing is that we are dealing with an assessment of an uncertain future within an uncertain environment.
Diversification is one way to navigate this journey so that your goals are met while better managing your risks.
Anet Ahern is CEO of PSG Asset Management.