Diversifying your portfolio by taking into account asset allocation and risk management
Successful savers and investors do not put all their eggs in one basket. Instead they look for exposure to multiple assets and instruments to reduce risk. When saving or investing through a single asset only, an investor has significant exposure when the price of that asset goes up or down. Yes, if it goes up, he or she might earn a good return, however if the price moves against them so their wealth will fall. Spreading risk across multiple investments and savings vehicles is known as diversification.
Diversification is not an exact science and is something that is unique to each portfolio and and the investor's or saver's goals. There is a misconception that diversification means purchasing many assets in a portfolio and the more assets one has the better diversified the portfolio. For example, simply increasing the number of shares in a share-only portfolio does not assist in balancing overall portfolio risk, as increasing shares is only effective to a certain point as seen on the graph below:
Limits of diversification in equity-only portfolio
Source: Rack Education
Of course, by increasing the number of shares in your portfolio you can diversify away company specific risk. But market risk remains regardless of how many shares you invest in.
Tips for diversifying effectively :
1. Invest and save through multiple asset classes
An investor and saver must not invest in only one asset class. Different asset classes respond differently to economic changes and having a healthy balance of asset classes means spreading risk as some will go up and some will go down in certain market events. Investors and savers should look to shares, bonds, money market accounts, commodities, and properties to diversify portfolio risk.
2. Invest and save in different geographic locations
Exposure to different geographic locations through offshore investments must be considered when looking to balance risk in a portfolio. Exposure to a single country makes an investor or saver vulnerable to the economic activities and political risk within that location.
3. Invest in instruments that do not move together
Your different asset classes and instruments in different locations must behave differently to one another. For example, gold tends to move in the opposite direction to the market and can be used effectively to diversify equity risk. Cash investments are linked to the repo rate; a decrease in the rate will impact the cash investment negatively, so look for assets that would do well if a rate cut were to happen like property shares. Likewise, investors based in emerging markets like South Africa will benefit most from a diversification perspective by investing in developed markets such as the US, UK and Europe since sentiment often favours one or the other.
