Diversification is a common term for most investors. Most of us would agree that diversification is summed up in the phrase “Don’t put all your eggs in one basket.” This phrase may capture the essence on diversification, but it does not divulge into what smart diversification actually is and the phrase certainly doesn’t tell us diversification’s role in an investor’s portfolio.
Is smart diversification investing our money with different investment companies and with different financial advisors? If you looked up the popular equity funds in South Africa, you would probably find that a lot of their top ten holdings are very similar. In fact, six of the top ten shares held by one of the largest fund management companies were also found in the top ten of another popular fund management company. So is this really diversification?
Although you invested your money with different fund management companies, many of the shares are the same and you could be unintentionally creating a strategy which investment professionals call “closet indexation”. Closet indexation occurs when a fund achieves similar returns to that of an index, but without replicating the index. This is not ideal for investors as we would achieve similar returns to an index but pay higher fees than an index tracking fund.
What is smart diversification?
Smart diversification has to do with creating a portfolio that includes multiple investments in order to reduce volatility. For example, if your portfolio only consists of one share, and that share drops significantly, your portfolio will face the full force of that fall in share price. It would be smarter in this scenario to purchase several shares in different business sectors in order to reduce volatility.
Another way to diversify and reduce volatility in your portfolio is to invest in other asset classes such as bonds, property and cash. The asset allocation of our portfolios should differ due to our time horizon, tolerance of volatility and our investment objectives. An aggressive investor with a long time horizon should have a larger allocation to shares than a conservative investor with a shorter time horizon. This is because shares, although volatile by nature, provide historically the best real returns over the long term.
Regardless of whether we are aggressive or conservative investors, asset allocation is one of the most important decision investors face.
Remember that your personal time horizon, tolerance for volatility and your investment goals should play the major role in determining the appropriate asset allocation to diversify your portfolio to maximise returns whilst minimising volatility. If you are too besieged by the amount of investment options available and/or do not have the time to research the asset classes extensively, speak to a Certified Financial Planner who can assist you in the decision making process.