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Investing101: Diversification explained

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Diversification is arguably one of the most commonly discussed topics in investment and retirement planning circles. However, it is also one of the most misunderstood concepts. 
 
If your money is currently tied up in financial markets, it is essential that you become familiar with diversification.
 
More importantly, you have to know what to expect from the strategy, otherwise you may have to settle for the deep fried tripe when what you really wanted was the grilled honey-glazed sirloin.
 
It is short-sighted to expect complicated financial terms like diversification to chalk up your wealth creation efforts or hope of making a killing in the stock market.
 
At the end of the day you need to understand what you are really dealing with.
 
►The idea behind diversification  
 
As the saying goes, don’t put all your eggs in one basket. The idea is that you spread your money across a wide variety of investments that behave or perform differently during certain phases of the business cycle (Learn more about the business cycle).
 
For example, during periods of poor stock market performance, bonds tend to perform relatively better. Certain investments or market sectors therefore deliver better returns under the same economic conditions. Needless to say, investors need to make sure they do not miss out on the action. 
 
One option for investors is that they diversify their portfolios across different types of assets, such as shares, bonds and cash in the bank.
 
If you have $10,000 to invest, you could place $5,000 in the stock market, $2,000 in a certificate of deposit and $3,000 in government bonds. 
 
Alternatively, you could buy into a mutual fund, unit trust or exchange traded fund. An individual fund may hold hundreds of different types of investments. This means that your $10,000 is automatically spread across different areas of the economy.    
 
What if you place your $10,000 in the bank or with one particular share? Are you diversified? The answer is no. Having said that, does owning a large number of different shares make you diversified? Not necessarily. It depends on how the individual shares behave relative to each other.   
 
So when it comes to compiling your investment nest egg, it lands up being a balancing act. Sectors that perform poorly should be counter balanced by areas of the market that generate good returns. But that’s a big should!
 
►Why diversify?     
 
Consider an investor who has placed all his eggs in one particular share. If the company shows good performance, he/she may enjoy good returns. If the company loses ground, his/her wealth creation efforts may run into trouble.
 
By placing all your resources in one basket, your returns become more susceptible to the ups and downs of the economy. In addition, you may lose out on positive returns generated by other areas of the market.
 
Diversification is a way of reducing the overall risk or volatility in your portfolio. A diversified portfolio can also produce more consistent returns over the long term without you having to make any market forecasts.
 
However, here is where the crunch comes in.
 
 
Diversification does not guarantee a profit, nor does it protect against a loss.
 

Furthermore, if the strategy of spreading your eggs is going to work, it will only work over a long period of time. So the question you need to ask is, ‘do you have the time?’

  • Does diversification work?
  • Will the technique give me above average returns?
  • Is it worth pursuing?

These are some of the questions we will be tackling in next week’s post.

In the mean time, I’d like you to consider the extent of diversification of your retirement funds and whether it has helped your investments during the 2008 credit crunch. 

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