The different dimensions of diversification
Diversification is like the old saying—“don’t put all your eggs in one basket”. Basically, by investing across lots of different things, you spread your money around, which means you take less of a hit if one of your investments loses value.
That’s all well and good in theory, but what does that actually look like in practice? We thought we’d give a few ideas around how you can actually make diversification happen in your portfolio—and what you should think about when you do.
Dimensions of diversification
Just like a shape has length, width, and depth, your investments can have different dimensions as well. Here are a few key ones to get you thinking:
The number of things you invest in: e.g. lots of investments, one investment, or somewhere in between.
Geography: e.g. investing some of your money in companies in New Zealand, and some of your money in companies overseas.
Sector: a group of companies in the same general area (e.g. the mining sector). By investing your money in different sectors, you’re reducing the risk of big changes in one specific sector (e.g. the price of minerals goes down and the mining sector takes a hit).
The kind of investment, also known as asset class: e.g. shares, bonds, cash deposits.
Using the numbers
One way to diversify is to invest in a bunch of different investments. For example, you could invest a little bit of money in each of the top 50 companies on the NZX. If you did this, you would be diversified across all different kinds of companies.
You’d have some banks, a milk company, and even the Port of Tauranga! Some of the companies in the NZ Top 50 are riskier than others, so you’d also be diversified across this dimension—if one of the riskier ones starts to drag you down, the other 49 can help to prop it up.
But you may not be as diversified geographically as you’d like. Most of the NZ Top 50 companies do business in New Zealand (makes sense). If something happened to the entire NZ economy, you might be a bit vulnerable.
If you wanted to be a bit more diverse, you could diversify geographically as well. You do this by investing in things in a variety of different countries or regions. This approach protects you from the ups and downs of regional economies. For example, the USA’s economy might dip a bit, while Australia’s economy trucks along with no problems—or vice versa. If you’re invested in things in both regions, you take the sting out of those local economic dips.
There are all kinds of exchange-traded funds (ETFs) and managed funds that specialise in certain areas, so you could distribute your money across a couple of these. On top of that, there are ETFs and managed funds that specialise in very large areas—like the entire world! If you invested in just one or two of these funds, you would be very geographically diverse.
Diversifying across sectors
You can also diversify by choosing certain sectors in the economy. For example, you might buy some shares in an electricity company, some shares in an airline and some shares in a construction company. By investing across three different sectors, you’re spreading your risk—that way, if something were to happen in one sector, you’d still have investments in two others.
Of course, this is just a hypothetical example—the actual economy is a lot more complicated than that. But it’s a good way to see how investing in different sectors can bring you more diversification.
Investing in a variety of funds like this gives you diversification across sectors, which means you’re protected from things that affect those specific sectors. If you invested some of your money in an ETF that specialises in the property sector, and property in general took a nosedive, you’d be protected if you also invested in other, unrelated sectors—like resources, water, or something completely different!
Diversifying across asset classes
Then there’s asset classes. Every investment is one asset class or the other. The easiest example to think of is shares and bonds. Shares are one asset class, while bonds are another asset class. They’re structured differently, and they give different returns.
Asset classes around the world sometimes move as a pack. So while investing in shares in different companies, regions, and sectors protects you from individual movements, it doesn’t protect you from a global dip in all shares.
One way to reduce your exposure to a single asset class losing value is to invest in other asset classes as well. For example, splitting your portfolio across shares, cash, and bonds. This gives an extra layer of diversification, because bonds pay a regular income where shares can be much less predictable..
What’s the catch?
Diversification is ultimately related to risk. The more risk you take, the bigger rewards you can get, but the higher your odds are of losing your money. If you put $100 in a savings account, you could make around $3 in a year—but you wouldn’t be taking much risk. If you spent $100 on lottery tickets, you’d almost certainly lose your entire $100, but there’s a (very) small chance that you’d get tens of millions of dollars.
Diversification is similar. Let’s say you invest all your money in one single company. If that company does really well, and doubles in value, you’ll get a really great return. But if that company goes under, you’ll lose everything. Ouch!
Now let’s say you invest your money in that original company, plus a thousand more companies. Now, that company only represents 1/1000th of your investment, rather than the whole thing—so if it increases value, your total percentage return will be much smaller than it would have been—but if it drops in half, your total loss will be much smaller, as long as the rest of the market doesn’t drop by the same magnitude.
Now imagine you invest in 10,000 different companies, or 100,000 different companies, with a bunch of bonds thrown in for good measure. The more you diversify, and the more dimensions you add, the more you spread your risk.
Where to from here?
By adding different dimensions to your diversification, you can reduce your risk more than you would by just investing in lots of different things.
The trick is to look at your investments and ask yourself how each one would respond to the same event. What would happen to your portfolio if the NZ economy had some problems? Or if oil went up in price? Or if there was a global share price decline? And so on, and so forth. Think of some big picture scenarios, and ask yourself how they’d affect your investments.
Then, if things are looking unbalanced, take some steps to balance things out. That’s how you can use the different dimensions of diversification to make your investing even more valuable, and put you in a better position in the future.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.