It sounds technical but diversifying is basically just the financial term for ‘don’t put all your eggs in one basket’.
You can diversify across assets and asset classes.
For example, if you invest in the stock market, you can hold a range of different shares or ETFs: that’s diversifying your assets.
But you could also hold investments across different classes, like bonds, property, art, crowdfunding shares, P2P lending, cash: that’s diversifying across asset classes.
You can diversify across industries and national economies by holding investments in global-facing companies or multiple companies in different countries and categories.
Well, it guards against risk. Risk is a rich and engaging subject, as well as a board game for masochists. We’ll talk more about risk in the future, but for now we’ll just look at the basics and how they relate to diversification.
Specific risk vs systematic risk
There are many flavours of risk, but to understand diversification it’s best to focus on specific vs systematic risk.
Specific or unsystematic risk
Specific risk is pretty simple — it’s the risk in investing in any individual asset. There are numerous factors at play here — e.g. internal issues like strikes, competition, unsuccessful products, bankruptcy, commodity prices, industry conditions — so even calculating this risk accurately is hard.
Some analysts look at past volatility in the stock price or the nature of the industry to assess the expected risk on a particular share.
This can’t cover every scenario though. Utilities companies are usually seen as low volatility shares. However, even for these companies an unexpected event, like the BP oil spill, can still arise.
In any case, diversification is your best protection against specific risk. By reducing your exposure to any particular stock or industry, you reduce your vulnerability to the unpredictable and predictable problems any company can face.
Systematic risk is risk to a market, asset class or financial system as a whole.
In stock market terms, this is what you’ll see during a market downturn, a recession or depression.
In 2008, a panic about dodgy complex assets and the financial firms who’d sold them escalated to a general panic over all market investments and a massive sell-off of all assets.
Diversification is still important, arguably more important in down times. It’s almost impossible that you’d see all firms and institutions go bust and diversified investors were protected from overexposure to the shakiest companies.
Systematic risk also covers less dramatic market downturns — simply investors cooling off the stock market and prices declining. Again, diversification will insulate you from excess losses on a particularly risky company.
As an inside, there’s also something called systemic risk. This is when individual companies or institutions have such a pivotal role that their problems can cause domino effect for the entire financial system or market. This was also in play during the 2008 crisis.
Diversification will dampen the downsides of systematic or systemic risk and effectively limit your exposure to specific risk.
How can I diversify?
Spread your investments. If you want to focus your portfolio on individual shares, it’s a good idea to measure your diversification against a simple metric. These aren’t a cast iron rules but it’s useful to have a yardstick. For, example you could:
- Avoid having any more than 5–10% of your portfolio in any one stock, unless you have a very good reason
- Hold at least 20 stocks overall (including stocks held through funds)
You should also look at different industries, countries and company growth stages (new, established) and find some balance across them. For instance, it’s probably not a good idea to have 100% of your portfolio in emerging markets tech companies. Even being 100% invested in big US blue chips isn’t ideal.
Ideally, you should look to build a portfolio of stocks with low correlation to each other: you don’t want all your investments to depend on the same set of circumstances.
If you’re not sure what particular shares you want, but do know you want to be in the stock market, a low-cost tracker fund or ETF can give you instant diversification across a whole stock index like the FTSE 100 or S&P 500, or even a huge basket of all the world’s stocks.
A popular diversification strategy is putting the bulk of their portfolios into tracker ETFs and then buying a few favoured stocks for some more ambitious investing.
You could also consider buying into other asset classes too. However, in general, as long as your timeframe is 5+ years, diversifying across the stock market should provide a good level of security.
Diversification is an essential part of investing strategy. It’s easy to get carried away on an exciting stock and go overboard. It’s also easy to look at a good performer in your portfolio in hindsight and regret not going all in.
Don’t be drawn into this! Smarts and discipline almost always beat luck over the long-term.
This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.
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