Diversification: reducing volatility and overall risk

Diversification

Why diversify?

We hear it so often from our financial advisers that it is important to diversify our investment portfolio, so we do not put all our eggs into one basket. But why is diversification so important in achieving our financial goals in the long run?

The logic behind this is that no single asset class, investment manager or security provides the best performance over the long term. As the returns from different asset classes, investment managers and securities will be different at any time, by investing broadly your overall return will tend to be less volatile. This is called “diversification” and is a common way of reducing volatility and therefore risk.

How diversification works

This concept is illustrated in the following simple graph. If you invested in stocks your returns over time are shown by the red line. If you invested in bonds your returns would have been the blue line. By investing half of your portfolio in each, your return would have been straight down the middle of the returns of each of the asset classes, and is shown with a green dotted line. The returns of stocks and bonds offset each other and the combined return is therefore less volatile. This example is only used as an illustration to demonstrate how two different investment vehicles can reduce volatility/risk. The highs of the Bond returns does not necessary offset the lows of equity.

Diversification can also happen within an asset class by putting for example equity of different characteristics into the same portfolio. This is one of the key benefits of mutual funds investment as a number of equity stocks are picked for you by the fund manager according to the investment objective set out in the fund. Look into the different types of funds to see what type of diversification strategy would fit your investment goals.

diversify chart

 

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