Investing – Diversification

What is diversification?

Diversification – spreading your investment funds or “not putting all your eggs in one basket” – is considered by specialists to be one of the fundamental keys to effective investment. Smart diversification allows you to factor out much of the volatility, and hence risk, associated with your investments. The key is to shape a balanced portfolio of investments under your overall strategy, rather than considering investments individually.

There are several forms of diversification:

Company diversification: where you counter the potential for falls in the returns of one company you’ve invested in, by purchasing shares in other companies not exposed to the same falls. For example, say a company that produces pulp and paper experiences a downturn in demand due to an oversupply on the world market. There is a subsequent drop in profit, and the share value falls. At the same time you’ve invested in an energy company that is operating at a time when demand for energy is high. By ensuring you’re not exposed to one particular sector, you reduce the risk to your overall share portfolio.

Regional/geographical diversification: where you buy some shares in the New Zealand market and some in other parts of the world where economies are larger and there are industries which are not found here. This is a means of factoring out under-performance by the whole share market in any single country, and expanding your options for company diversification.

Manager diversification: where you don’t have enough funds to purchase your own diversified parcel of shares so you buy into a managed fund which enables smaller investors to participate in a wider range of investments. You can diversify even further by choosing several different fund managers, as each tends to hold expertise in different areas.

Asset class diversification: where you buy into a variety of asset classes to counter downfalls in other classes. Investors who spread their risk among several asset classes should expect a better risk-adjusted return than those who use a single asset class.

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