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It’s all about diversification

The trinidad Guardian / Investing well means managing risks. One of the best ways to manage risk is through asset diversification.

We’ve all heard the saying before “don’t put all of your eggs in one basket” and, in a real sense, this is what portfolio diversification seeks to avoid.

Fundamentally, diversification involves allocating investments among various financial instruments, industries and other categories to mitigate against any serious financial losses that could be incurred from being too heavily concentrated in any particular area.

Diversification also allows for maximising returns from investing in different areas that would respond differently to the same event.

While diversification does not guarantee against financial losses, the general consensus among investment professionals is that diversification is one of, if not the most important aspect of reaching long-term financial goals while at the same time minimising risks as much a possible.

In terms of risks, there are generally two types that investors are faced with: diversifiable and undiversifiable.

Diversifiable risks (also known as unsystematic risks) are those which, through careful asset selection and allocation can be reduced.

They are specific to a company, industry, country, economy or market. Put differently, an investor can avoid making a financial mistake in these areas simply by assessing the data presented on these categories and determining to omit them (in whole or in part) from his or her portfolio.

The ultimate aim is to invest in various assets so that they will not all be affected by market events in the same way. This brings us to undiversifiable risks.

Also known as systematic risks, they are the risks born out of areas over which investors have very little control. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification; it is just a risk that investors must accept.

Areas such inflation, exchange rate volatility, interest rate movements and even political instability are forces that operate in markets which an investor simply cannot avoid.

To make the need for diversification more vivid, it’s worthwhile to consider the following arbitrary example. Suppose an investors owns only stocks of oil refineries.

If it is announced that refinery workers are going on an indefinite strike, and refineries begin to shutdown, it is quite likely that refinery company share prices will tumble. The investor will experience a significant drop in the value of his portfolio.

If however, the investor were to counterbalance his portfolio with say stocks of banks and financial companies, it is quite likely that only part of his portfolio would be affected since the two areas are not strongly correlated (at least in theory).

The fact that a shock in one area (oil workers strike) has minimal impact on another company or sector is the essence of what diversification tries to capture – reducing the potential for financial losses associated with concentration.

In fact, a strike by oil refinery workers could have a positive effect on other sectors (perhaps alternative energy companies) and as such an investor would do well to have both areas as part of his portfolio.

It’s also important to invest across different asset classes (such as stocks and bonds) as both are unlikely to react in the same way to adverse events (generally speaking the bond and equity markets tend to move in opposite directions).

In spite of the best analysis of a company or industry, diversification does not guarantee that an investor will not make losing investments.

Markets by their very nature involve multiple actors who can behave in unpredictable ways.

Diversification can however, help an investor manage risks and reduce the volatility associated with the movements in an assets price.

The key is to find a happy medium between risk and return.

This will help an investor to achieve his financial goals while being able to rest comfortably at night.

Andre Worrell

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