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Why diversification in investment is important

September 10, 2012

Here's some guidelines why you should never "put all your eggs in one basket".

FEATURE

By Lee Ching Wei

Diversification is by far the most underrated and least understood concept in investing. Intuitively, it should make sense. You shouldn’t “put all your eggs in one basket”.

The US Securities and Exchange Commission provides an excellent example of this concept on its website:

“Have you ever noticed that street vendors often sell seemingly unrelated products – such as umbrellas and sunglasses? Initially, that may seem odd. After all, when would a person buy both items at the same time? Probably never – and that’s the point. Street vendors know that when it’s raining, it’s easier to sell umbrellas but harder to sell sunglasses. And when it’s sunny, the reverse is true. By selling both items – in other words, by diversifying the product line – the vendor can reduce the risk of losing money on any given day” Source: www.sec.gov

The key takeaway is in the last sentence. When we diversify, we reduce the risk of losing money. Many investors claim to understand this, but their actions suggest otherwise.

Think having a 50 stock portfolio provides you with enough diversification? Not if all 50 companies operate in the same country and are susceptible to the same economic forces.

Think having all your money in the local bank gives you virtually no chance of losing money? Not if the currency depreciates sharply (yes, you may not “lose” money when the currency depreciates but the purchasing power of your money decreases. We are living in a “global economy” after all).

Think having a few investment properties protects you from a weak property market? Not if all your properties are of similar type (e.g. residential apartments) and are located in the same geography.

In fact, multiple mortgages often increase the risk, as any gains or losses are amplified.

So what constitutes a well diversified portfolio?

Generally, a well diversified portfolio has little exposure to any particular factor or event. These factors or events could be as broad as the economic conditions of a country, or as specific as the location of a property.

The difficulty is in identifying and reducing your exposure to as many of these factors or events. As a rule of thumb, there are two ways you could improve the diversification of your investment portfolio:

  • Increase the number of investments, or
  • Increase the type of investments.

A portfolio of 50 stocks is almost always less diversified than a portfolio of 5,000 stocks, and the latter is almost always less diversified than a portfolio of 5,000 stocks with some allocations to bonds and cash.

People often think you need a large pool of money to have a diversified portfolio. After all, how else can you own a portfolio of 5,000 companies if you only have a few thousand ringgit to invest?

The good news is – this is a myth. Today, with as little as a couple of thousand ringgit, it is possible to own thousands of companies and hundreds of residential apartments, office buildings or shopping malls from all around the world – through exchange trade funds (ETFs) and Real Estate Investment Trusts (REITs).

The best part is – it often does not cost much to do this.

The writer is the founder of iMoney.my, a price comparison website in Malaysia. They can be contacted at [email protected]


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