Diversification - spreading your risk
Risk and return go together, as we’ve noted. The higher the risk, the more likely you will receive high returns in the long run, although there will be ups and downs along the way.
The reverse is also true. You can’t get high returns without taking risk. If anyone ever tells you otherwise, run a mile! They are almost certainly scammers.
Generally, you can’t reduce your risk without reducing your return. But there’s one exception to that. By spreading your money over a range of investments you greatly reduce your chances of losing a lot of money. And yet your average return is unchanged
Let’s look at an example. In a single share, the range of likely returns within a year might be minus 100% (if the company goes bust) to plus 200% (if the company does really well). And in a managed fund that holds many shares, the range of likely returns for each of those shares might be the same minus 100% to plus 200%.
But not all the shares will rise or fall together. When some fall others rise. And it’s pretty much impossible to imagine all the companies going out of business at once. So the range of returns on the whole fund is more likely to be, say, minus 50% to plus 150%. Your average return hasn’t changed, but your volatility has. Some experts call diversification ‘the only free lunch in investing’.
There are several types of diversification
- Within one type of investment. You might hold lots of different shares – preferably in many different industries. This could be through buying all the shares yourself, or through investing in a managed fund that holds shares. Or you might hold lots of different bonds, or several properties, perhaps including commercial and residential properties. Again, you can use a bond or property fund.
- Across types of investments. It’s a good idea to own some shares, some property, some bonds and some cash – in or out of managed funds. They almost certainly won’t all lose value at once.
- Internationally. You can reduce your exposure to one economy by holding investments in several different countries. An easy way to do this is through a New Zealandrun managed fund, so you don’t have to worry about international tax issues and so on.
- Range of terms. If you invest in term deposits or bonds, you could have some that mature soon and some that mature later. Then they won’t all come up for renewal at a time when interest rates happen to be low.
It’s a good idea to diversify in all these ways. The easiest way to diversify is to invest in a managed fund.
This content is reproduced from ‘Hits and Myths: an introductory guide to investing by Mary Holm’.
Download the Hits and Myths Guidebook by Mary Holm