Q: You often hear the word “diversification” when investments are discussed. What does it mean and how does it work? —Name withheld upon request, sent via Facebook
A: Diversification is important. In fact, it is considered one of the most effective risk-management tools, minimizing investment losses.
What does Investopedia (a favorite online site for investment concerns) say about diversification?
It says diversification is “a risk-management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
“Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”
Diversification is often misunderstood and its execution has always been a mystery to many.
To many of us, diversification is about putting money in different banks or buying different pieces of property in different areas.
However, diversification is much more than that. Here are some ways to diversify:
1) By asset class—Cash or near cash (savings or checking accounts, time deposits, treasury bills or money market accounts); fixed income (government securities, corporate bonds); equities (stocks); real estate; collectibles (paintings, jewelry, etc.); enterprise (business)
2) By time frame—Short term (about a year); medium term (up to about five to seven years); long term (over seven years)
3) By risk—Conservative, moderate, high or speculative instruments
4) By liquidity—Highly liquid vs non-liquid investments
My advice? Vary your asset classes; combine short-, medium- and long-term investments; combine highly liquid and nonliquid assets.
By practicing diversification, you are also practicing sound risk management. A properly constructed diversification strategy will minimize the risks of your investments and, at the same time, give you better yields as compared with taking an ultra-conservative position. With a good diversified portfolio, the risk of totally wiping out your wealth is highly unlikely. And at the same time, it allows you to experience better growth, which will exceed inflation.
But diversification also has its downside. Sometimes, a portfolio that is too diversified can also prevent you from earning properly, as the volatility of many of the players in your portfolio can cancel each other. However, having a very risk-averse position can be just as dangerous as taking a risky option, as inflation can erode the value of your wealth. The more prudent option then would be to learn diversification.
Do not be too afraid to try out diversification, it is not rocket science. Come up with a diversified program that is consistent with your investment objective, risk tolerance and time frame and you are on the road to achieving financial peace.
I really like the way the Bible talks about diversification. Yes, the Bible is a good source of investment wisdom and here’s proof: “But divide your investments among many places, for you do not know what risks might lie ahead.”-Ecclesiastes 11:2 (NLT) Since the Bible advocates diversification, I am assured that it’s a great idea.
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Randell Tiongson is an author, columnist, speaker and advocate of personal finance. Follow Randell at www.randelltiongson.com To learn more about financial planning, attend our FREE personal finance talk on July 3, 7 p.m. at PSE Ortigas. To reserve, email info@rfp.ph or text <name><email><RFPinfo> at 0917-3464126.