Putting all your money into one investment can pay off spectacularly, or go horribly wrong. Here’s how diversification spreads that risk, and why it’s one of the most important ideas in investing.
Diversification is the investing version of not putting all your eggs in one basket.
If you invest everything in a single company and it collapses, you could lose most or all of your money. If you spread your money across many investments, a problem with one has a much smaller effect on your overall wealth.
Nobel Prize-winning economist Harry Markowitz, whose work in the 1950s laid the foundations of modern portfolio theory, showed that combining investments that don’t move in exactly the same way can reduce risk without necessarily reducing returns. Diversification is often described as the only free lunch in investing.
Ways to diversify
There are several layers of diversification.
The first is across companies. Owning shares in many businesses, rather than one or two, reduces the impact of any single company’s problems.
The second is across industries. The Australian share market is heavily concentrated in banks and miners, so an investor who owns only the biggest local companies can still be exposed to a downturn in those sectors.
The third is across asset classes, such as shares, bonds, property and cash. These often behave differently. When shares fall sharply, high-quality government bonds have often held their value or risen, cushioning the blow.
The fourth is across countries. Australia makes up only a small share of the world’s share markets, and investing globally gives access to industries, such as large technology companies, that are barely represented on the ASX.
How most people diversify
Most Australians are already diversified through superannuation. A typical balanced or growth option invests across thousands of companies in Australia and overseas, along with bonds, property, infrastructure and cash.
For individual investors, exchange-traded funds and managed funds offer an easy way to diversify, because a single investment can hold hundreds or thousands of shares.
The limits
Diversification reduces risk, but it doesn’t eliminate it. In a severe crisis, such as the global financial crisis, most share markets around the world fell at the same time.
Spreading money too thinly can also make it hard to keep track of investments and can add costs.
And diversification works both ways. Someone who put everything into a single company that soared would have made far more than a diversified investor. The point of diversification is not to find the biggest winner, but to avoid being wiped out by the biggest loser.
