Diversification is strategy of investing in multiple asset classes and among many securities in an attempt to lower overall investment risk.
Whilst we all know that, broadly speaking, equities return more than bonds which return more than cash over time, it is also true that these average returns are not normal.
The table below shows the returns of various asset classes over various periods to the end of 2015.
Source: Old Mutual
As can clearly be seen. Even though South African equities was the best-performing asset class over the full period, it was not the best over all periods (and over some periods it was in fact the worst).
By diversifying ones portfolio (see below how one can diversify), an investor can decrease their risks of missing their objectives.
Reasons for diversifying
There are a number of ways in which an investor can diversify their portfolio and avoid the risks associated with being too concentrated. The more homogeneous a portfolio is, the more it is susceptible to the risks associated with the asset class or sector or geography or industry etc… the portfolio favours. On the other hand, the more diverse a portfolio is, the less susceptible it is to any one risk or to any risks which may affect a particular asset class or sub-class.
For example, if a portfolio is only exposed to one asset class or asset manager, then should something happen which negatively affects that asset class or asset manager, then the whole portfolio will be significantly affected. On the other hand a portfolio which is spread across a number of asset classes or asset managers will be less impacted by such negative activities.
Types of diversification
Asset class diversification – where you don’t just invest in a single asset class, but spread your risk across more than one.
Sub-asset class diversification – where you don’t just invest in for example, government bonds but also inflation-linked bonds (and you can also diversify across different bond issuers and across bonds of differing duration etc…)
Sector diversification – where you invest across multiple sectors in an economy (industrials, financials, resources etc..)
Industry diversification – where you invest in different industries (manufacturing, services, retail etc…)
Geographical diversification – where you invest in different regions or geographies so that you can decrease country-specific and region-specific and market-specific risks etc…
Currency diversification – where you invest in more than just one currency so that you are not solely tied to the value of that currency at any one time.
Security diversification – where you invest in more than one company for example or more than just the bonds issued by a single company so that you are not solely linked to the trials and tribulations of just that company etc…
This is not an exhaustive list and many of these categories can be broken down into smaller components.