What is Portfolio diversification?

Diversification is a method of portfolio management whereby an investor reduces the volatility of his portfolio by holding a wide range of different investments that have low correlations with each other. It simply entails spreading your risk across different types of investments.

Diversification is important in investing because markets can be volatile and unpredictable.

Warren buffet once said, don’t test the depth of a river with both feet. In a lay man’s language, it means don’t put all your eggs in one basket. As an investor, you should consider investing in different asset classes such as stocks, bonds, real estate, mutual funds, et al. Avoid high exposure to a single class of asset. Ensure you have a mix of investments in your portfolio.

How does portfolio diversification work?

The basic idea behind diversification is that the positive performance of some investments will compensate for the negative performance of other investments.

Also, in diversifying your investments, be conscious of the fact that you can have variety of options even within an asset class. For example, in equity investing you should spread your investment across the various sectors listed on the stock exchange. You can consider shares of banks, fast moving consumer goods (FMCGs), oil and gas, telecommunications et al, this is because these different sectors will react differently to risk and economic changes.

Let’s talk about the benefits of diversification:

Firstly, diversification minimizes the risk of loss to your overall portfolio: While a single asset class can suffer huge declines, it is very rare that any two or three assets with very different sources of risk and return, like government bonds, real estate and equities, would experience declines of the same magnitude at the same time. So even if equities dipped by 40%, your bonds and real estate would keep your portfolio from falling so much. This is why diversification is important in your investments.

Secondly portfolio diversification exposes you to more opportunities for return, considering the mix of investments.

Thirdly, diversification safeguards you against adverse market cycles and reduces your portfolio volatility.

Now let’s use an illustration to drive home the point.:

Sharon is a banking officer in one of the leading investment banking firms in the country, at the beginning of the year she got a bonus of N2,000,000 from her employer. Sharon then allocated the funds by investing in Treasury bill, mutual funds and equities. Few months later she had a financial emergency and she needed to liquidate an investment to meet her financial obligation, the stock market was bearish considering her entry level, she couldn’t liquidate her treasury bill because it was locked in for a 364-day period, however she was able to cash in on her mutual funds. This is a classic case of benefits that accrue from portfolio diversification.