When the word diversification first comes to mind, one will tell him/herself that it is the process of starting to include various types of businesses into an already existing business. But diversification means different things to different people.
The American industrialist Andrew Carnegie once said, “Keep all your eggs in one basket, but watch that basket closely.”
Diversification is a fundamental principle in investing that involves spreading your investments across various assets. By allocating your money to different asset classes, sectors, and geographic regions, you can mitigate the impact of adverse events on your investment portfolio.
Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. This article will explore the concept of portfolio diversification, its benefits, risks, and strategies to help you make informed investment decisions.
Understanding portfolio diversification:
Imagine you have N1m to invest. You decide to put all your eggs in one basket by investing it all in a promising-looking stock. Unfortunately, the stock takes a dip, and your investment loses a significant amount of value.
What if you had diversified your portfolio? Instead of putting all your money into one stock, you could have spread it across different asset classes like bonds, real estate, and alternative investments. This would have cushioned the impact of the stock’s decline. Even if the stock had lost value, the gains from other assets could have helped offset the losses.
Different aspects of diversification
Sector/ Industry Diversification: This involves investing in companies from different industries, such as technology, healthcare, finance, and consumer goods. Sector diversification can help to mitigate the impact of industry-specific risks.
Asset class diversification: This involves investing in different types of assets, such as stocks, bonds, real estate, and commodities. Each asset class has its own unique risk and return characteristics.
Geographic diversification: This involves investing in companies from different countries or regions. Geographic diversification can help to reduce exposure to country-specific risks, such as political instability or economic downturns.
Style diversification: This involves investing in different investment styles, such as growth, value, or blend. Growth stocks are expected to experience rapid growth, while value stocks are undervalued relative to their fundamentals.
Different ways to diversify
Mutual funds: These pooled investment vehicles offer a convenient way to diversify your portfolio. Mutual funds and ETFs can invest in a wide range of assets, including stocks, bonds, and real estate.
Individual securities: You can also diversify your portfolio by investing in individual stocks, bonds, and other securities. However, this requires more research and time to manage.
Alternatives: Alternative investments, such as hedge funds, private equity, and commodities, can provide diversification benefits. However, these investments often have higher fees and may be less liquid.
What Is an example of a diversified investment?
These vehicles are diversified by purchasing shares in different companies, asset classes, and industries. For instance, a diversified investor’s portfolio may include the stocks of retail, transport, and consumer-staple companies, as well as bonds — both corporate- and government-issued. Further diversification may include money market accounts, alternative investments, and cash.
Benefits of diversification
Diversification attempts to protect against losses. This is especially important for older investors who need to preserve wealth toward the end of their professional careers. It is also important for retirees or individuals approaching retirement who may no longer have stable income; if they are relying on their portfolio to cover living expenses, it is crucial to consider risk over returns.
Diversification is thought to increase the risk-adjusted returns of a portfolio. This means investors earn greater returns when you factor in the risk they are taking. Investors may be more likely to make more money through riskier investments, but a risk-adjusted return is usually a measurement of efficiency to see how well an investor’s capital is being deployed.
For some, diversifying can make investing more fun. Instead of holding all your investment within a very narrow group, diversifying means researching new industries, comparing companies against each other, and emotionally buying into different industries.
Potential problems with diversification
Professionals are always touting the importance of diversification but there are some downsides to this strategy. First, it may be somewhat cumbersome to manage a diverse portfolio, especially if you have multiple holdings and investments.
Diversification also can be expensive. Not all investment vehicles cost the same, so buying and selling will affect your bottom line, from transaction fees to brokerage charges. In addition, some brokerages may not offer specific asset classes you are interested in holding. Note, however, that recent trends toward zero-commission trading in stocks and ETFs have greatly reduced the cost of putting together a well-diversified portfolio.
Also, consider how complicated diversified investing can be. For instance, many synthetic investment products have been created to accommodate investors’ risk tolerance levels. These products are often complex and aren’t meant for beginners or small investors. Those with limited investment experience and financial wherewithal may feel intimidated by the idea of diversifying their portfolio. Unfortunately, even the best analysis of a company and its financial statements can’t guarantee it won’t be a losing investment. Diversification won’t prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.
It is also important to note that diversification, however, can have a negative impact on portfolio returns. When investors use diversification, they do not have a significant concentration in any one investment or industry sector in an attempt to capture high returns.
This is because a diversified portfolio is optimized to achieve the highest risk-adjusted returns, and not the highest absolute returns possible. Thus, diversification may cause an investor to miss out on the potential high returns of a specific stock, asset class, or market segment that is outperforming. The key is to find a happy medium between risk and return. This ensures you can achieve your financial goals while still getting a good night’s rest.
In his view, Chief Executive Officer of Wardiere Oakmount, Kunle Ilori-Diamond, insisted that diversity is difficult for a serious business owner to finish the move adding that diversification is not just about doing multiple businesses but about “it is about creating layers of wealth by strategically venturing into complementary industries. Here are some principles I’ve found invaluable.”
Giving a step-by-step rule for achieving successful diversification, Ilori-Diamond stated that an investor must first have a stable foundation before diversification.
He emphasised that diversification is layered and not simultaneous to avoid crashing a successful move.
He said, “Start with a stable foundation: Before diversifying, ensure your primary business has stood the test of time. This doesn’t necessarily mean operating for decades but achieving consistent profitability and cash flow. A solid foundation is essential because diversification is most effective when your first venture is already scaling successfully.
“Diversification is layered, not simultaneous: Many successful entrepreneurs you see today didn’t launch multiple businesses simultaneously. What you witness is the culmination of years of gradual expansion. Diversification should be seen as an evolving portfolio strategy, not a hasty plunge into unrelated ventures.”
He also added that when a first business is thriving, the following guidelines should be adopted to maintain the momentum in a challenging economy;
- Complement your core business: Diversify into industries that align with your main business. For instance, a real estate entrepreneur can venture into furniture making, interior decoration, or construction materials like block manufacturing. This creates synergy and maximizes your expertise.
- Minimise capital risk: Choose businesses where your capital remains secure, even if the venture fails. When you choose a business where you don’t have to lose your capital, it ensures you can recover and regroup if necessary.
- Avoid debt-heavy ventures: If borrowing is unavoidable, ensure your assets outweigh the debt. This way, liquidation can cover your obligations without financial ruin.
- Respond to existing demand: Diversify into businesses that address proven market needs. A simple approach is to identify services your current business frequently outsources and create solutions for them. Let your primary business become the first client of your new venture.
- Prioritize cash flow: At least one of your businesses should generate steady cash flow. A profitable but cash-flow-deficient business can strain resources, especially if paired with another that ties up funds in assets.
