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You've probably heard the term "diversify your investments" thrown around more times than you can count. But what does it really mean, and why is it so important?

At its core, diversification is a strategy that involves spreading your investments across a range of assets to reduce risk. In simpler terms, it's the old adage of not putting all your eggs in one basket. But the concept runs deeper than mere risk mitigation; it's a fundamental principle that can potentially enhance returns and safeguard your financial future.

Imagine you have $10,000 to invest, and you decide to put it all into a single stock because you think the potential returns from that company, and the potential ‘risks’, suit your personal risk appetite. If that company performs well, you could see significant gains. However, if it experiences a downturn, your entire investment could suffer. This is where diversification comes into play.

Now imagine there were 10 different companies, all with the same ‘risk’ as the first company. This means that, on average, each company has the same chance of going up or down in value, by similar amounts. If the $10,000 investment is spread evenly across all 10 companies, the total risk of the portfolio goes down, without impacting the expected returns!

Over any given time, some investments are likely to outperform the average, and others will perform worse. With a larger portfolio of investments, if any one investment performs badly it is more likely to be balanced out by other investments that outperform.

Investment risk is the uncertainty or variability of returns

Investment risk is often measured as the variability of the investment’s returns. A ‘low risk’ investment might be something that doesn’t give great returns, however its performance in a ‘bad’ year isn’t too bad either. In other words, the variation in performance between good years and bad years is pretty small, so there is more certainty around the level of returns to expect.

On the other hand, a higher risk investment might be something that, over time can be expected to give much larger returns, but the difference between the gains in good years and potential losses in bad years might be much larger: This investment has more uncertainty and variability, but higher average returns.

Diversification is all about levelling out the peaks and troughs, so that you can still get the higher average returns, but if the peaks and troughs come at different times for different investments, then the overall variability of your returns should average out, meaning lower variability of returns and lower overall risk.

Correlated and uncorrelated investments

Since the magic of diversification relies on levelling out the peaks and troughs across multiple investments, it’s important that you don’t have too many investments that are likely to have peaks and troughs at the same times. Two investments are said to be ‘correlated’ if, when one is performing well the other tends to also perform well, or when one is doing badly the other is also likely to be doing badly. An example of correlated stocks might by the shares of two different oil companies.

If you ‘diversify’ an investment from one stock, to invest in two stocks that are correlated, then you’ll miss out on most of the benefits of diversification. The peaks and troughs of performance will tend to align rather than cancelling each other out. Instead, you need to look for new investments where their performance has little or no relationship with the performance of the other investments in your portfolio.

Diversifying between and within asset classes

By spreading your investments across different asset classes such as stocks, bonds, real estate, and commodities, you can cushion the impact of poor performance in any one area. For example, while stocks may be subject to market volatility, bonds often provide stability during turbulent times. Similarly, real estate can offer steady income through rental payments, while commodities like gold can act as a hedge against inflation, i.e. the value tends to rise when inflation is high. Investing in any one of these assets on its own brings volatility, but because their performance has very little correlation, its likely the peaks and troughs of performance will tend to cancel each other out.

But diversification isn't just about asset classes; it's also about diversifying within those classes. Investing in a mix of industries, geographic regions, and company sizes can further reduce risk. By diversifying between, and within asset classes, you can get higher average returns with lower overall variability, i.e. lower risk.

Balancing between high and low risk investments

Diversity of higher-risk and lower-risk investments is also crucial. While high-risk assets offer potential for greater returns, they also come with increased variability and possibility of significant losses. On the other hand, low-risk investments provide more predictability, but typically offer lower returns. Balancing both allows investors to pursue growth opportunities while mitigating potential downsides.

Moreover, diversification isn't a one-time task. As your financial goals, risk tolerance, and market conditions change, so too should your investment strategy. Even where your investment strategy hasn’t changed, the proportion of different investments in your portfolio will naturally change over time as some increase in value more than others. To retain your same risk profile, you need to regularly rebalance your portfolio by selling some of the investments that have become a larger portion, and buying others that are not correlated. This ensures the overall mix remains aligned with your objectives and maintains an optimal level of diversification.

While diversification can't guarantee profits or protect against all losses, it remains one of the most effective risk management tools available to investors. By spreading your investments across a variety of assets, you can potentially increase returns while reducing the impact of market fluctuations.

In essence, diversification is about building resilience into your investment portfolio. It's about harnessing the power of the variability of different investments to create a stronger, more sustainable financial future. So, the next time you hear someone talk about diversifying their investments, remember that it's not just a buzzword—it's a strategy that can make all the difference in your journey toward financial success.

By Joshua Pan