The different dimensions of diversification

We talk a lot about how we’re big fans of diversifying your investments. This is the basic premise: by investing across lots of different things, you spread your money around, which means you take less of a hit if one of those investments loses value. It’s like the old cliche—“don’t put all your eggs in one basket”.

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.

Diversifying geographically

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 can invest in an ETF that includes Australian resource companies involved in energy, metals, and mining, or a managed fund that invests in global water companies that are trying to solve the global water crisis.

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 deal with this is to invest a little bit in other things, some of which might offer less of a return, but have less risk. If you look at most KiwiSaver providers, you’ll see that this is exactly what they do. Even the long-term growth funds tend to be 70 or 80% shares, and 20-30% fixed interest—also known as cash and bonds.

This gives an extra layer of diversification, because bonds pay a regular income where shares are much less predictable.

That steady predictability also means that bonds sometimes move in the opposite direction to shares. If companies and governments aren’t offering very high regular payments, then investors will try to make their money elsewhere, in places like the share market. With more people competing for shares, shares tend to go up in value.

Then the opposite can happen too. If bonds start paying a higher amount per year, some people will be happy to just invest their money in bonds instead of shares. They’ll sell their shares and buy bonds instead—and if enough people do this, bonds will go up in value while shares go down in value.

So diversifying across different kinds of investments can take some of the sting out of the ups and downs of the share market.

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 the same way. 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 it halves in value, 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 when it doubles in value, your return will be much smaller than it would have been, but you have really protected yourself if it halves.

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 less risk you take, and as a result the less chance you have of being an overnight millionaire—but the roller coaster ride of investing becomes a bit more comfortable!

Where to from here?

The good news is that if you’re investing with Sharesies, you’re probably already diversified, because every ETF and managed fund is a basket of lots of different companies. But by adding different dimensions to your diversification, you can reduce your risk even further.

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 a return, and you might lose the money you started with. Before investing, you should read your fund’s product disclosure statement. It contains the investment objectives, risks, fees and other information. You should carefully consider this information in relation to your investment time frames and goals.