Henry Kabue, a Research Analyst at ICEA LION Asset Management, the investment management arm of ICEA LION Group, takes us through why you should diversify your investment portfolio.
What is Diversification in Investing?
Diversification is the process of allocating money across a wide range of assets within a portfolio of investments in order to limit the risk to any single asset. E.g., income from interest-bearing instruments such as treasury-bills may offset the impact of capital losses on your investment in the stock market within an investment portfolio.
The rationale behind diversification is that a portfolio consisting of different kind of assets will, on average, yield higher long-term returns and lower the risk of any individual asset.
In summary, diversification is a risk management strategy that speaks to the old adage; “Don’t put all your eggs in one basket” prescribes to investors that we should avoid putting all the eggs in one basket.
What is the Importance of Diversification?
Although it does not guarantee against loss, diversification is the most important component of achieving higher returns in the long-term. This risk management strategy allows investors to minimize risk and maximize opportunity through access to a broader range of investments.
How many investments are required for a well-diversified portfolio?
The optimal number of investments required to achieve the benefits of diversification remains an ongoing debate. Definitely, owning five stocks in a portfolio is better than having one, but there comes a point when adding more stocks to your portfolio ceases to make a difference. E.g., a portfolio consisting of 10 stocks can lack diversification if all the stocks are in one sector because the emergence of negative developments in that sector could lead to losses that affect the entire portfolio.
Investors must ensure that they understand the risks that affect different types of investments before allocating money in the portfolio, whilst bearing in mind their risk appetite. A robust understanding of risks will guide an investor’s decision-making on whether to increase or reduce exposure to particular investments.
What is an Example of a Diversified Portfolio?
Investors can diversify their portfolios across different asset classes including stocks, bonds, real estate, commodities as well as cash and short-term cash equivalents e.g. treasury bills.
In addition, investors can diversify further within the different asset classes by selecting a broad range of securities. E.g., an investor can choose to have both corporate and government bonds in the bonds asset class. In addition, an investor can choose to have manufacturing, banking and technology stocks in the equities asset class.
Illustrations of diversified portfolios as per below:
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