We have all heard the old adage 'don't stick all your eggs in the one basket' and this pretty well sums up the theory behind diversification. It is generally accepted practice when constructing your portfolio that you should spread your exposure to different asset classes and assets within those categories. However, diversification can become counter productive and as Mark Twain once observed: Behold the fool saith, "Put not all thine eggs in the one basket"--which is but a manner of saying, "Scatter your money and your attention;" but the wise man saith, "Put all your eggs in the one basket and--WATCH THAT BASKET." So which is it? Are we being foolish or wise?
The answer to this question perhaps lies in how much time and confidence you have, to pick and then watch 'your basket'. Often investment gurus will tell us that if we follow their rules, diversification per se is not necessary. All it does is dilute the superior returns available through prudent investment. However as Mark Twain also noted, "All you need in this life is ignorance and confidence, and then Success is sure". Unfortunately, the investment annals are littered with the carcasses of failed investments, confidently thought worthy at the time, but which ultimately spelled disaster for investor's savings. All too often, we see entire life savings wiped out when the practice of diversification is not followed. In the world of investment, it is unfortunate that the very thing that makes us confident enough to put all our savings in one investment (whether that be an inherent belief in the company, property etc, or the marketing that has persuaded us), also tends to make us ignorant of the risks we subject ourselves to. However, it's hard to remain ignorant of the ensuing loss.
If you question your ability to pick the right investment at the right time, diversification has its benefits. So what is it? Very simply, it is the spreading of your investment dollar across multiple investments with a view to lowering risk. Just like you can invest in shares across a range of different companies and different industries (retail, finance, mining, oil, technology etc) you can also invest across the different asset classes such as Australian shares, International shares, property, cash and fixed interest. Each asset class has further diversification such as property which can diversified through geographic location or type such as retail, commercial, residential and industrial properties. The theory here is that diversification can help ensure that a slump in any one investment, location or sector does not have a catastrophic effect on your portfolio.
If you invest through a managed fund you will naturally have some diversification due to the range of shares/bonds/properties etc. each fund would invest in. You can further diversify your portfolio by investing in a number of managed funds. Different funds have different managers who in turn have varying investment philosophies and this can affect each of their performances significantly. However, there is a point where this becomes what is jokingly called 'diworsification'. Holding too many managers (or indeed too many direct stocks) becomes diversification for diversification's sake. This adds to expense, administration, perhaps risks you taking your eye off the ball in relation to individual investments, and achieves nothing positive. For example, if you hold more than two or three Australian share managed funds, you would probably be better off buying the index, because this is effectively the exposure you have (you just pay more for the privilege).
So the theory (and practice) of diversification is about mitigating risk to the degree practical without letting it get in the way of making a profit. The decision to add another investment or class of investment should be carefully considered. What does it actually add to your portfolio in probable return (that is, it is either increasing the potential return, or the likelihood of a specific return being achieved). If the answer can't be identified, then cash is probably the best diversifier you have available at that time. In the second part of this article on diversification we'll look more specifically at some of the diversification methods used.
