Wednesday, 15 July 2015

We often hear that investors’ portfolios need to be diversified, that we shouldn’t have all our eggs in one basket. But what does this actually mean? And how do we know we have properly diversified our portfolio? Sometimes we invest in asset classes we think will provide protection when the economy has a downturn, only to find they lose value at the same time – and to the same extent as the other asset classes we hold.

A well-diversified portfolio will combine asset classes in such a way that, no matter what the underlying economic environment, it will not suffer losses to the same extent as if it was ‘concentrated’ (the opposite of diversification) in just one asset class.

Think of a balanced diet. Doctors remind us of the benefits of eating a balanced diet, recommending our daily food intake consists of some of each of the main food groups. Say you only ate vegetables – while healthy, this isn’t a balanced diet. To give yourself the best chance of performing at your potential for longer, it would make sense to eat other foods as well, like meat, grains and dairy. 

Investing is similar. Say your portfolio consisted of 100 per cent shares. As we saw in the post on asset classes, these will tend to do well when the economy does well. But when economic activity is negative, shares tend to do poorly. If you’re seeking to protect your capital and minimise the effect of a market downturn, it makes sense to hold other asset classes to diversify your portfolio. Some people advocate that one way to do this is to buy corporate bonds. But is this the right sort of diversification?

Let’s examine the economic drivers of each. Corporate bonds are essentially IOUs from companies listed on the stock market. These are the same companies whose shares you own. An economic environment that causes investors to worry about a company’s ability to make profits and pay dividends is very likely to be the same environment that also causes investors to worry about whether that company can pay back its debts. The end result is when the economy turns down, the prices of both the company’s shares and its bonds will probably fall together. This is not effective diversification. A better approach would be to buy asset classes that are likely to do well when share prices fall. Government bonds are one such asset class. Physical property or infrastructure assets are others and cash is yet another.

By diversifying your portfolio you are acknowledging that you don’t know precisely what the economy and markets will do in the future. So you spread your risk.  Concentration on the other hand is essentially betting that your view of the future turns out to be 100 percent correct, all of the time. It’s like eating an unbalanced diet: it will be ok for a while, but may not be the best strategy to reach your long term financial goals.


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