What is... | November 12, 2013

What is diversification?

Spreading risk is a well-worn idea and investors are often prodded to diversify. But what does diversification really mean?

Diversification in saving and investment terms means avoiding holding too much of one’s wealth in only a few assets, a seemingly simple statement with many implications. In investing literature, diversification is often used to warn against owning only a few shares rather than holding several shares or investing in a market index fund.

However, diversification may also refer to mixing investments between shares, bonds, property and cash or even opening savings accounts with several banks if you have large amounts of cash earmarked for different purposes.

Thinking about the principles behind diversification may help you understand the potential dangers of buying shares in the company or industry you work. Likewise, it may clarify the implications of owning a house if tempted to buy another property to rent out in the hope of making money or providing income in retirement.

Why diversify?
The theory goes that diversification helps to spread financial risk by mixing a variety of investments. The idea is that prices of different kinds of investments (such as cash, bonds, property and shares) tend to be driven by different factors. Or in the most basic terms, if one falls the other might rise, or at least lose less.

One way to think of diversification is that it is the opposite of putting all of your eggs in one basket.

How much of any one asset should be held?
The amount of diversification a person can and should take depends on many personal factors. When people are young and with few commitments, such as children to care for, it can make sense to build investments – perhaps in a pension fund – with a very high concentration in shares.

Older people may wish to diversify their investments into more than shares. This is the main idea behind lifecycle investing, which can be thought of as form of diversification. Here are three examples where diversification should be considered.

1. Don’t put all of your basket into one Apple
When investing in share markets it’s sensible to diversify across companies and industries. However, thinking traps such as “availability bias” can skew our judgement because we may favour investing in shares regularly mentioned in the media.

In October 2012, for example, according to portfolio monitoring site SigFig, nearly 17% of all individual US investors held shares in Apple, three times as many who owned Google. The share price that month reached over $670, six months later it had slumped to under $400 – highlighting the perils of putting so much faith even in a wildly-adored company.

2. Keeping the right company
Another instance where the merits of diversification are often ignored are company share schemes. Because of these incentives employees may have a large proportion of their investments tied to the performance of just one company – they are said to be “over-exposed”.

This is a risk (as this poll suggests) they may never consider otherwise. What if the company fails? Employees could lose their jobs, their savings and their pensions in one tragic turn of events.

3. Home or away?
Investors should also consider different geographic regions to mitigate the effects of “home equity bias”, the tendency to over-invest in your home country. Developed markets (perhaps Europe, the US or Japan) may offer slower growth but more stability.

Conversely, emerging markets, such as (at the time of writing) India, China, Brazil or Russia), may offer the potential for more growth but also more risk.

In any case, be vigilant...
You may have heard that the value of investments can go down as well as up, but in some instances this can mean all your investments. The recent financial crisis in 2007/2008 saw shares in all sectors across the world slide, as well as commodity falls and a property slump.

Be warned: as ING Group chief economist Mark Cliffe in his sixth video lesson from the financial crisis says, even the most diverse portfolio can crash.


eZonomics team
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