Diversification

Are we doing diversification wrongly? We may think that we are well-diversified when in actual fact we are still concentrated largely in one area or type of investment. Why should we even practice diversification in the first place, wouldn't it dilute our returns on the good investments?

(Source: flickr.com, Simon Cunningham)

Diversifying is useful in reducing the overall risk of our portfolio. By spreading our capital over more investments that do not correlate 100% with each other, we increase the chance that our capital will be affected by a downturn in the particular company or industry. It helps us reduce our risk to the undiversifiable risk, which is that of the market as a whole or maybe even less if we use invest in other instruments like bonds.

An example, let's say that there are two companies, one that makes money when it is raining and another that makes money when it is sunny, they are inversely correlated. When it rains, the first company will rise in value while the second company falls in value and vice-versa. Buying the shares of these two companies will reduce your risk due to the changes in the weather. But there's still the risk of the market as a whole climbing or falling, which is the undiversifiable risk as it affects all the companies' shares.

But we can invest in other classes such as bonds, gold, etc. to help reduce our risk even further. This would help to reduce the overall risk of our portfolio, however, it will be at the expense of our returns (if we are able to pick the winners well that is)

So, as you may have noticed, to diversify well, we have to choose investments that are not related or inversely related. Some people may think that they are well diversified even though all their shares are quite closely related, like holding all the companies in the same industry or related industries (such as oil and gas and shipping companies) or holding the companies in the same geographical region, such as all Singapore companies. These portfolio are likely to be affected by a general downturn in the particular industry/ group of industries or factors local to that geographical region.

Companies that also fall into the same category, such as defensive or aggressive companies, would also be affected by similar factors, so even though a supermarket like Sheng Siong and a waste disposal company like Colex may not seem related, but they are both defensive companies that are likely to do well (relative to the other companies) when the economy is bad and not as well when the economy is good.

In conclusion, diversification is a good idea for us to reduce risk, but we need to do it correctly, or we might just be in the illusion that we are well-diversified when in fact, we are not.


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