Worried about making the wrong investment? Try diversification.

Worried about making the wrong investment?

Diversification and asset allocation are simply about not putting all your eggs in one basket.

The ancient book of Jewish laws and knowledge, the Talmud, said: “Let every man divide his money into three parts, and invest a third in land, a third in business and a third let him keep in reserve.” Translated into modern investment assets, that becomes a portfolio of stocks, property, and bonds.

These days, we have many more asset classes to achieve that diversification, such as stocks, bonds, commodities, gold, hedge funds, private equity, etc. So, here are the 5 things you need to know about diversification.

Spreading your risks

While it is true that all investments come with an element of risk and the possibility of making a loss, there are proven ways to mitigate such risks.

The first step is to understand yourself. You can start by learning more about your personal risk appetite and clearly identifying your goals before you start investing.

The second step is to enhance yourself. This refers to your financial knowledge in the investments that you want to make. As the saying goes, knowledge is power. By grasping what you are investing in, you minimize the likelihood of making the wrong decision.

The third step is to mitigate your risks. Diversification is one way to manage your investment risk without necessarily holding back your potential investment returns.

How does diversification reduce risk?

Diversification is all about spreading your investments across many different baskets. By placing your capital in different investments, it reduces the likelihood of your investment from being wiped out.

Thus, when risk assets like stocks are sold down during times of market distress, investors tend to buy quality government bonds, which in turn drive up the bond prices. In this instance, declines in stocks are offset by gains in government bonds.

Citing another scenario, sometimes when inflation becomes a concern, stock prices might fall due to worries that the former may move up interest rates. Nonetheless, the same dynamics might also raise commodity prices, which can help a diversified portfolio offset some of the losses in stock prices.

Types of diversification

Broadly, there are a few major types of diversification. Among which, asset class, geographical, sectoral and securities or stocks diversification are the most typical.

Diversification by asset class

Diversification through asset class is the most common. This is done through investing in uncorrelated assets. For example, a well-diversified portfolio consists of a balanced allocation of investments in equities, bonds, commodities, property and cash.

A correlation describes the relationship in the movement of prices of different asset classes. A correlation coefficient of +1 suggests a strong positive correlation, implying that both the asset classes move in the same direction and by a fixed proportion. A coefficient of -1 indicates a strong negative correlation, that is, the two asset classes move in opposite directions by a fixed proportion. A coefficient of zero suggests no correlation at all.

To use correlations in spreading risk, look at the assets’ long-term correlations. To achieve a diversified portfolio, you need to have asset classes with either negative or low correlations with one another.

Diversification by country and industry

Among each type of asset classes, there are investments that will span across different geographic location and sector. This is best explained with equities where each company has its own geographic area of operation and its own industry (e.g. Technology, healthcare, consumer staples). Diversification can be achieved by spreading investments in different country and industry to minimize the impact of country or industry specific events.

Diversification by investment style

Apart from country and industry, diversification can also be achieved through investment style. Stocks can be classified into different categories based on market capitalisation (small, mid and large cap) and style (growth, income and value). There are nine categories in total, from small cap growth stocks to large cap value stocks. For example, Amazon is a large cap growth stock. A good mix of stocks with different market capitalisation and style will help you to create a portfolio that may be more resistant to economic shocks.

With the right diversification through different investment instruments, you can reap the rewards of investing and still maintain a low exposure to risk.

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