Diversification is a popular theme espoused by financial advisors. As long as there is a geographical or business sector not included in your portfolio, you'll tend to hear them sharing axioms such as “you shouldn't put all your eggs in one basket” and “diversify to reduce your risk”.
But does diversification surely reduce risk? I am sometimes left scratching my head when asked to diversify into an area where I am not invested in, for the simple reason that I am not invested in it: it does not make sense to diversify into risky areas for higher returns when I can obtain a similarly high returns at less risk. It is equally mind-boggling when bankers advise parking money in financial instruments that is going to give returns lower than the inflation rate. This “diversifying for the sake of diversity” approach is sadly rampant these days.
However, if diversifying can reduce risk while maintaining or even enhancing returns, then it is definitely a great idea to do so! Diversification though, is a really vague phrase, I've grown to realise. Some people thinks that diversification means having a portfolio covering almost every investment out there. Others think holding around 5 different shares is diversified enough.
Due to the intrinsic nature of diversification, being a concept in the dynamic investment discipline, and the difficulty in quantifying investment risk, it is not possible for it to have a fixed quantifiable yardstick. How should we diversify in this case?
These guiding principles are my two-cents:
- Bearing in mind short-term market volatility, pick investments where the risk versus reward is at least comparable to those in your portfolio.
- Based on the above guideline, have as large a variety of investments as you can safely monitor. The size of your portfolio is limited by your time.
- Do not diversify for the sake of diversity.
Here's wishing everyone a prosperous and bountiful year ahead!