The Importance of Diversification


Depending on your approach, you either get it… or your eyes just glazed over.

But… don't let them. Truly, your investment future might depend on it.

(And I'll try to make this both short and interesting!)

Diversification pretty much just means not putting your eggs in a single basket. It's about spreading your risk so that, if the worst was to happen, it wouldn't bring your entire portfolio down with it.

Which, I think, is kinda worth paying attention to!

And… that's pretty much about it, really.

If you've read and understood what I just wrote, you're well on the way to making sure your portfolio is ready to ride the investment waves, with the best chance of reaching your destination without sinking along the way.

What follows, then, is a short summary of the 'how' of diversification.

And, a little work on definitions.

See, as I said, diversification is about spreading your risk. But it's not just having a certain number of companies. After all, you could buy 8 different bank stocks on the ASX. But that's not exactly diversification!

Yes, you're diversified by company. And, if one bank went broke for completely company-specific reasons, you'd be okay.

But… it's far more likely that any issues confronting one bank would be confronting them all, making the presumed diversification look far more like concentration!

Instead, you should be assessing your portfolio for overlapping 'risks'. Things like consumer spending, house prices, changes to industry regulations, moves in currency, or improvements in technology. Using risk factors should give you a different lens on your portfolio, and highlight were there might be more concentration that you first assumed.

It's also important to think properly about industries or sectors. Some people have a lot of 'technology' exposure in their portfolios. Which seems overly concentrated, no?

Except that description isn't very useful. After all, which companies don't use technology these days? And the ones that are considered 'tech stocks' can all be very different from each other.

What do Apple, Facebook, Netflix and Cisco have in common? They're all 'tech stocks', but couldn't be more different from each other in terms of their actual businesses.

So, when you think about diversification, I want you to think about three key areas:

1. Industry (the actual ones, not the share market groupings like 'tech' or 'utilities')

2. Geography (not just where a company is listed, but where it makes its sales and profits); and

3. Currency (kinda like the above, but with a focus on the impact of foreign exchange in particular)

Now, I'm not asking you to make forecasts on any of those things. I'm not saying 'trade the dollar' or 'buy consumer staples companies'. I'm saying you should understand the composition of your portfolio, trying not to be too concentrated in any one of those factors, and actively looking for opportunities to broaden your portfolio on all three, if the investment stacks up.

Don't buy (or sell) just because of an academic exercise – always do the company analysis first! – but also include diversification questions in your Buy and Sell decisions, asking yourself what each potential transaction does to the composition of your portfolio.

And lastly… did you notice I didn't mention share prices? We're long term investors. We don't worry about short term share price movements, and we're not trying to 'diversify away' volatility. We're not hedging or using stop-losses or anything else.

We might feel that volatility, but we're training ourselves not to care about it. To ignore it. And, even better, to take advantage of it. But we're not building a portfolio that in any way tries to manage it.

As ever, keep your eyes on the (diversified) long term, Fools. 

Fool on!