Diversification: Why All Your Eggs Should Not Be In One Basket
Diversification is a word that gets thrown around a lot in finance, but what does it mean? Essentially, it embraces the idiom, “Don’t put all your eggs in one basket.” If you drop the proverbial basket, all your eggs are at risk of becoming scrambled. Similarly, if all your money is in a single stock, there’s a high risk your portfolio will plummet, and you’ll be scrambling to recover your losses.
Got it. So, how do I diversify?
Plain and simple: spread your money out across many sectors, countries and their currencies, asset classes, and cyclical/non-cyclical stocks. Cyclical stocks generally consist of companies selling consumer discretionary items, such as luxury brands, airlines, hotels, and car manufacturers. These stocks are volatile and follow the market, so if the economy rises, stock prices will surge.
People have more disposable income to spend on luxuries during an upturn. If a recession hits, these stocks can plunge. They can become worthless as companies go out of business: not many people will prioritise a fancy hotel stay over their mortgage payments.
Non-cyclical stocks, also called defensive stocks, include companies providing essentials like gas, electricity, food, and drink, which naturally outperform the market during a recession. They can be a great way to hedge your bets during a downturn as people always need to eat and turn the lights on, even during a market downturn.
Wow, defensive stocks sound great! Can I fill my portfolio with those?
Non-cyclical/defensive stocks sound fantastic, and they are in certain circumstances, but the trade-off is the rate of investment return. Cyclical stocks are more volatile, which means higher highs and lower lows over a much shorter period than you’d see with defensive stocks.
Non-cyclical stocks will return a far lower rate while cyclical stocks are soaring, so you ideally want a portfolio that incorporates both cyclical and defensive. This way, you can make the most of high investment returns from the cyclical stocks, but you have the security of defensive stocks if the market drops.
Diversification is a balancing act, and you should be looking to incorporate it into your portfolio from the beginning. A healthy balance between asset classes (bonds, stocks, and money market/cash) makes your portfolio more resistant to market moves.
Why should I invest in bonds, stocks, and cash, and what’s the difference?
Similar to cyclical and non-cyclical, stocks and bonds have different rates of return and risk, and asset classes tend to have little correlation, although this has changed over time.
A healthy mix of the three asset classes is ideal, with specific proportions supporting different risk tolerance/attitudes, also known as “asset allocation.”
For example, a cautious investor worried about losing money may go for a split of 20% stocks, 50% bonds, and 30% cash. An aggressive investor chasing returns would aim for 100% stocks with minimal bonds and cash.
Bonds are considered safer as they are the debts of issuers, which include governments and companies. However, they can still be risky, as the issuer may fail to pay back their debt. This is most likely to happen with corporate bonds rather than government bonds.
Bonds usually pay a regular income through interest, which can be helpful for those on a fixed income. Bonds run against interest rates, so bond prices fall when interest rates increase and vice versa. If interest rates fall, the fixed interest paid by a bond can be a desirable, safe-looking investment proposition, and the inverse also applies.
Stocks can have their value wiped out overnight if a company declares bankruptcy, is caught up in a scandal, or something happens to the industry as a whole. Take airline stocks, for example; when the pandemic first hit, airline stocks plunged. EasyJet lost 60% of its value in a month. Even now, in July 2021, with travel opportunities opening up again, it is still down 45%.
Meanwhile, Coca-Cola took a 36% hit in the same month but was only down by 8% at the end of 2020. This highlights the importance of investing in different types of stocks: EasyJet and Coca-Cola are cyclical and defensive, respectively.
Money market funds are a strategy for playing it safe. They offer higher returns than a bank account. Still, there’s no capital appreciation over time, so they’re not the place to leave your money for the long term unless you accept that you won’t be accumulating any returns on that part of your portfolio, but matching inflation.
These funds are liquid, so they can be used as an interim investment before putting money elsewhere. Cash in a portfolio can limit losses during a market decline. It can also create a psychological comfort knowing that money in a portfolio won’t decrease if the market takes a nosedive. This strategy could reduce the urge to panic sell in the middle of a financial crisis and crystallise all losses. It could encourage an investor to ride the wave.
The three asset classes above are the most common, but you can also invest in real estate, gold, artwork, etc. These are often highly illiquid, so you should consider this if you want them in your portfolio. You can sell bonds in a pinch, but selling that bungalow will be trickier!
Diversification sounds like a hassle.
In some respects, it is! However, it’s a much better strategy than putting all your money in one place. Yes, fees are higher when you invest in different areas, but you’ll often find that the returns outweigh the costs. This is especially true if you invest in higher-risk funds for an extended period, five years or more, where you will often see any lows recover.
It can be a hassle to keep an eye on a portfolio with many different investments. However, there are many diversified managed funds invested worldwide in various industries that can reduce your need to monitor your portfolio.
In summary:
Diversification is a sensible tool to utilise for your investment or pension. Taking a broader look at asset classes rather than purely individual stocks can reap huge rewards and mitigate risk. Hopefully, this article has thoroughly explained diversification in simple terms, showing the importance of including it in your portfolio. It’ll help you ride the highs and lows of the market regardless of your risk attitude.
