On your weekly shop, you’ve cherrypicked a basket of fresh goods. You bring it home. Start to unpack. Hungry, you bite into the apple… and realise it’s rotten at the core. Bummer.
Every so often, you buy a basket of fresh goods and some of the items will be rotten. Sometimes, what appears fresh on the outside, will actually be rotten on the inside.
That’s exactly why diversification is important. You’re better off keeping a mixed bag of goods, because if you pick the rotten apple, there’s bound to be another one in the basket ripe and ready.
Now, let’s leave that basket alone, and bring this back to investing.
Diversification is about lowering risk. Put simply, diversification means spreading your risk across a variety of investments. That way, if one asset performs poorly, your other investments help offset this poor performance against the performance of the rest of your portfolio.
In financial markets, there are two main types of risk – systematic risk and unsystematic risk. Sounds relatively simple. Unlucky for us though, systematic risk and unsystematic risk can go by several different names, sometimes making things seem more complicated than they really are.
When something has the potential to threaten financial systems, it’s known as systematic risk. These risks are macroeconomic in nature and include currency rates, inflation rates and interest rates. Regardless of what you’re invested in, it’s difficult to avoid systematic risk.
But there are some risks you can avoid. Unsystematic risks are specific to companies or corners of the market, but they generally won’t impact the entire financial system. An example might be an inexperienced CEO being appointed to head a company, an industry being lumped with a big new tax, or a company collapsing on bad debts.
The best way to avoid these risks is to diversify. Diversification means spreading risk across several investments. It’s basically a fancy term for the old saying ‘don’t put all your eggs in one basket’. If you invest across a range of different assets and asset classes, you are less likely to be negatively impacted by one ‘egg’ in your ‘basket’ underperforming.
Consider the graph above. Risk generally decreases as the number of securities in a portfolio increases. As you can see, investing across a range of assets tends to be a good idea for all investors.
However, it’s not just about the number of assets, but also the correlation between the assets. Correlation simply relates to the relationship between the assets, and negative is better than positive here.
If assets are positively correlated, they tend to move in the same direction. So, if one asset experiences positive returns, the other asset also experiences positive returns. If assets are negatively correlated, they often move in the opposite direction. If one asset performs poorly, the other asset is more likely to perform well. Investing in assets that are negatively correlated is generally a good idea.
But working out the negatively correlated from the positively correlated can be tricky, which is why ETF investments are becoming so popular. ETFs are a cost-effective way for everyday investors to access a fully diversified portfolio. When you purchase shares in an ETF, you are effectively buying a basket of stocks. The team at InvestSMART handpick the best ETFs to and weight them correctly in each of our portfolios.