What is Diversification and How does it Work?
We’ve all heard that we shouldn’t put our eggs in one basket. If that one basket falls, gets stolen, or is attacked by a fox, then you’ve lost everything. In terms of investment, this principle is very important.
As you dip your toes into international share trading, you need to dabble in multiple markets. This way, if one of your markets takes a dive, your other assets will keep your portfolio in the black.
What exactly is diversification?
Diversification is spreading out your risk by mixing many different forms of investment. In offshore trading, this translates into purchases in different stocks and shares. Trading novices may pick one solid-looking brand and sink all their funds into it. That’s how a lot of people ended up in Bitcoin.
Ideally, you need to distribute your investment into various profitable buckets as part of your risk management strategy. Some stockbrokers suggest that investing in foreign markets is the very definition of diversification. Diversification works on the basis that negative performance in one sector of your portfolio can be balanced out with positive results from another investment bucket.
Localisation has its drawbacks
If you restrict your deals to local brands, or to one geographical region, then a shake-up in that physical space will affect all your stocks and shares. For example, a crisis like political turmoil, terrorist attacks, or even crime against a tourist could shake up an entire market’s prices and deeply affect that region’s currency.
If all your investments were based on this locality, then your portfolio will take a dive. However, suppose this negative event frightened investors into moving to another market. If you had already invested in that other market, that sudden influx will strengthen your holdings, and this spike could be enough to cancel out the dip from your troubled market shares in the initially affected region.
Benefits of diversification
In this sense, diversification has two tactical benefits:
- It minimises volatility.
- It facilitates the identification of risk factors.
When novices hear about the principle of diversification, they make a common beginner’s mistake of spreading themselves too thin. They purchase minimal stocks and shares in hundreds of different brands. Diversification works best if you restrict yourself to 100 brands or less. Anything more than that isn’t investment: it’s gambling.
Another common error in share trading is to focus on stereotypically successful brands. You may argue that everyone needs a phone, and that technology drives economies, so you end up investing in the top telco from each of your selected markets.
Same eggs, different baskets
While this is sound in theory, the reality can get messy. A general shake-up in technology – such as the discovery or a revolutionary of new component, or the depletion of a crucial mineral element – would affect all telcos, no matter where they are based. This could essentially soar or sink your portfolio.
For diversification to be effective, you don’t just need different markets, You also need different sectors. Each of your holdings should be as distinct as possible from one another. You could – for example – select a telco, a construction firm, a medical service provider, a fashion house, an ice cream manufacturer, and so on.
On to the second point, financial risk can be systematic or unsystematic. Think of unsystematic risk as a more localised factor. It’s a negative event that only affects one company. For example, a top executive could fall sick, or get involved in a sex scandal. Or one of the company’s products could be used in a crime and end up getting blacklisted by global security agencies.
Understanding the types of financial risk
Unsystematic risk will affect that particular company, but the spill-over is relatively limited. The social effect might trickle down. Journalists may look more closely into the health of CEOs that haven’t been in the public eye for a while, or similar products may tighten their liability clauses. That said, the financial effects will largely remain within the confines of the individual company. This kind of risk can’t be anticipated or planned for. Any response to such crises is largely reactive.
On the other hand, systematic risks have precedent, and you can take speculative actions to avoid them. You may have heard about billionaires who buy shares when they’re crashing. At this point, everyone else is selling, so an investor can scoop millions of shares at rock-bottom prices. It’s a systematic risk, but it’s not one the average investor can take.
Invest like a billionaire … or don’t
These types of decisions are what were used during the Great Depression to build up families like the Rockerfellers and the Rothschilds. This doesn’t necessarily mean you should sink all your savings into Bitcoin, now that its price is plummeting. Remember, this kind of decision took generations to pay off, and those two families could afford to lose a few billion dollars as they waited out the decades of economic depression. You probably don’t have that luxury.
Systematic risk is therefore far more calculating. You can study the market and spread your risk based on factors like regional instability, discovery of natural resources, population progression and so on. Your purchase decisions in the various markets should be driven by opposing – or sometimes complementary factors, but they should be varied enough that they don’t spill over onto each other. This keeps your portfolio more profitable.