It’s a term you see whenever you read about investing, and it’s something you’ll be told over and over by anyone who works with investments, like a financial advisor. But what does “diversifying” your investment portfolio actually mean?
Well, it means that you should invest in a mix of assets, like equity (shares), bonds, property and cash, for example. Furthermore, those different assets could also focus on different industries, or they could be based in different countries with different currencies. By diversifying, you’re deliberately creating an investment strategy that isn’t tied to the performance of one asset type, industry, country, currency or investment instrument.
Remember the saying, don’t put all your eggs in one basket? Yup, diversification is exactly that.
Why does diversification make sense?
Most investments carry some kind of risk. Diversifying your portfolio by spreading your money across a variety of assets effectively spreads that risk, too. You’re not at the mercy of one investment that might perform poorly and cause you to lose a good chunk of savings.
Sadly, there’s no crystal ball that allows us to see into the future. If there was, we could choose that one amazing investment that would give us the best return possible for as long as possible. In the real world, you only know if you’ve made a bad call after you’ve experienced a loss. You’ll still experience losses here and there in a diversified portfolio, but they should balance out against gains made in other areas.
Give me an example…
Consider two neighbouring farmers, each of whom must decide which crops to plant for the next harvest. After doing some research, Farmer Tom reckons there might be a global wheat shortage on the horizon. He decides to only plant wheat. Farmer Andile is unsure whether a wheat shortage will actually materialise and decides to rather plant several other crops alongside some wheat. Andile is diversifying while Tom is not.
Now let’s look at two extreme outcomes. In the first outcome, there is indeed a wheat shortage and given the demand, Tom is able to make a very good profit on his harvest. Andile also makes a good margin, but because he planted less wheat he doesn’t make as much as Tom.
But what if it turns out that there’s no wheat shortage? In fact, there’s a global oversupply! This brings down the market price of wheat and Tom ends up making a loss. Andile, on the other hand, makes normal profits on his other crops and comes out better overall than his neighbour.
So, what should I do?
Of course, there could be several other scenarios in the example above that aren’t as clear-cut. The point is that you should diversify if you want to moderate your risk and prevent wholesale losses. On the same note, if you’re looking for a big win and you’re prepared to take a gamble on a single investment, you must also accept that there might be an equally sizable loss…
As always, when you’re planning for the future and looking to grow your wealth, it pays to get the right advice. Chat to a qualified financial advisor who can look at your situation holistically and suggest how you can start to build a diversified and prosperous investment portfolio.