You might have heard about diversification when it comes to your investment portfolio, but what about the rest of your financial situation? What about your source of income? What about the country you live in? What about the currency in your bank accounts? In this article we're going to explain how diversification really works, and why it goes further than the numbers on your investment app.
To put it really simply, diversification is done to avoid concentration risk. If you've not heard that term before, concentration risk is the risk you take by having too much of your money in one place. It's like putting your life savings on the number 8 at the roulette table, rather than spreading it around. You shouldn't do either of those things with your life savings though.
For another example, imagine you're at a restaurant. You've narrowed your choice down to a tasting platter with 6 small taster portions, or the fillet steak. If you go for the fillet steak, you're increasing your concentration risk. You've got one shot for an amazing meal. If the steak is seasoned and cooked to perfection, the whole meal is going to be awesome. If it's tough and tasteless, you've got nothing to fall back on.
The taster platter is diversified. You might have 3 amazing items, 2 averages ones and 1 that you don't like at all, so even though they weren't all perfect, overall you still had a really nice meal.
The key to proper diversification isn't just about increasing the number of assets you hold, it's also about whether these assets all tend to go up and down at the same time. This is called correlation. If you're investing in shares and you buy 6 technology companies, that's not diversification, because they're all likely to go up and down in roughly the same way.
So it's important to try to reduce concentration risk in a portfolio by spreading your investments across areas that have low levels of correlation where it's possible. Many advisors will only focus on the diversification across asset classes, but we know if goes deeper than that. When it comes to getting real diversification for your money, you need to cover these four main areas.
This is the obvious one. Diversifying across different asset classes can reduce the volatility in your portfolio and give you greater options for things like income. There are five main asset classes that most portfolios will invest in.
Stocks & Shares
Fixed Interest, Bonds & Gilts
Property and Infrastructure
Alternatives such as commodities, precious metals, private equity funds/venture capital funds, cryptos, wine and jewellery
The level of diversification at the ratio of assets held within these will depend on your attitude to risk, the returns you're chasing and the level of fluctuations you're prepared to accept.
Within these asset classes are a huge number of industry sectors to invest in. These will often move in different ways. The technology sector will perform differently to the oil and gas sector depending on what's happening in the economy.
By spreading your investments across a range of different sectors, you have the potential to continue to make money in the stock market even if large sections of it are falling in value.
Just like different market sectors can go up and down at different times, so can different countries. They all have different economies with different strengths and weaknesses. Even among developed economies like the UK and the US, there can be differences in how they perform year to year.
This goes even further when talking about emerging markets like Brazil, China and India. Good returns can be had in these places in some years, with huge falls experienced in others.
Lastly, assets all over the world are priced in different currencies, and these all move differently due to lots of external factors, such as the strength of their economies or international demand and supply. The level of diversification you want for the currency of the assets in your portfolio will depend on where you plan to live.
If you expect to stay in one country your whole life, you might not want any currency diversification at all. If you want a more global approach, maybe you want lots of currency diversification. It all comes down to your own financial needs.
So far we've talked about diversification within your investment portfolio, but what about the rest of your life? The more of your finances that are tied to one of those 4 key areas above, the greater the risk in your financial life.
If you invest in the UK, earn your income in the UK, own a property in the UK and hold mainly pounds sterling in your bank accounts, you have a huge level of concentration risk. Even if you move your investments into a diversified portfolio, your financial security is still heavily tied to the success of the UK economy. It's really important to keep this in mind when you're looking at your finances as a whole.
Lastly, the point to remember is that diversification narrows the potential outcomes in both directions. If you invest into 1,000 different companies, they're not all going to be winners. Some will be great, some will be rubbish and lots will be in between. Your overall return will be the average of all of that.
If you instead invest everything into one company, your potential outcomes are much wider. If that single company does an amazing job, your returns could be phenomenal and way above the market. If that company goes bankrupt, you could lose everything. This is called a single company risk and investors should always aim to avoid it.
So whilst diversification reduces the risk and reduces the volatility, it may not maximise your returns. If you're at the casino that might not be how you want to play it, but when you're talking about your financial security, it's worth leaving some potential return on the table.