There is a very old saying - Don’t put all your eggs in one basket.
In other words - diversify.
Diversification is an antidote to risk. It is a means of combining investment assets together as a group to produce a result that is less risky than the individual assets by themselves.
Expressed not so simply, diversification is about lack of correlation, co-variance, unsystematic risk, and modern portfolio theory.
Expressed simply it is about spreading your investments.
There are those investors who argue that they have diversified by placing their funds in two different banks. If interest rates fall these investors will suffer a loss in their investment returns overall so risk has not been reduced, it has merely been averaged.
Diversification has various levels.
The first level applies to the bank example above as well as to say shares. If you invest in a balanced portfolio of shares the failure of one will not as badly harm the portfolio overall.
The second level is asset class diversification. Asset classes are usually defined as cash, fixed interest, property and shares. In normal times each of these different investment sectors will be subjected to different influences and so they will not move up or down in the same direction and to the same degree as a share only portfolio might, for instance.
The third level of diversification works best with managed funds and is called manager style diversification.
Using shares as an example, if we were to use two managers, both of whom were aggressive stock pickers then when the market rose or fell these investments would tend to perform in similar ways.
If we combine a growth manager with a value manager then we will tend to get different performance over shorter periods and will have diversified risk.
No one manager will have a style that is appropriate for all times. Combining different styles can be easily done and is an effective risk management tool.
The fourth level is diversification between NZ and international markets. If the NZ market is suffering it will have little influence on international markets which could just as easily be going the other way.
Diversification as we should understand it is a simple concept that deals with reducing risk so that slow and steady progress can be made towards achieving a specific financial goal rather than an all out charge with one or two investments which as a strategy can easily end in failure.
