“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
- Warren Buffet
Diversification
Same return, Less Risk
There exists a general misconception that diversifying leads to lesser returns. This, however, is not always the case, IF diversification is applied properly. I have chosen Warren Buffet's quote at the top of this page because he beautifully illustrates what diversification is about. If you know what you are doing, if you have all the necessary and correct information, plus the required expertise in order to value assets, you don't need to diversify. Then you are just able to pick that one asset that is most undervalued, or which you will know will appreciate most in the near future, and you put all your wealth into that asset. The issue is that many people, including myself, don't have the necessary, nor correct information, or the required expertise to value every asset adequately. Not only isn't it just always possible to have access to the right information and analyse it with the required expertise, some parts of the information are just not 100% sure. Who is to say how consumers will react to a new trend? How a war will end? Who will foresee the next natural disaster?
Some people are less ignorant about specific topics, and hence Warren's Buffet quote at the top of this page. I think it is up to the investor to diversify against his own ignorance, and inability to control the flow of information. If you are an investor active into Venture Capital, you just have about access to all the company's financial information and it is way easier to make predictions on the company value. Nonetheless, even there you can not know with a 100% certainty whether or not your venture will be successful. If however, you are into stock-, bond- or fund investing, (1) you will posses way less required information, about (2) a high number of assets, on which (3) you will not have control.
Diversification of your investments basically is the same as diversifying your risk. By making your investments dependent on different risk-elements instead of one, you can actually lower your risk, while maintaining the same average return. A nice example of this is the Modern Portfolio Theory. Another advantage of diversification is that you can better accommodate your needs in terms of your investment goals, and retirement and wealth planning.
Diversification of your investments basically is the same as diversifying your risk
Types of diversification
Diversification can be done
in many different
ways
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Geographical diversification means that you diversify your risk over different geographical locations. Those locations can be both geographically determined (regions, borders, ...) as economically (i.e. monetary unions). Think of geographical risks as every risk element that can affect a specific region: Earthquakes for regions (Japan), political tensions for countries (Trump elections), monetary crisis for a monetary union (Eurozone).
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Diversification of sectors and industries means that you make your investment less dependent on one sector or industry. In the case an industry or sector gets hit, i.e. by a change in consumption trend (smartphone), by a change in policy (Tobacco, Oil & Gas), or by a disruptive innovation (Uber), you are still covered by other sectors and industries.
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Diversification within sectors and industries -note the difference with the above paragraph- occurs when you buy assets from different companies which are active in the same sector or industry. As such, you are betting on an appreciation of the entire sector or industry for whatever the reason might be. If one company would miss the boat on the next trend (i.e. Nokia), you would still be covered by investments in other companies.
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You can achieve diversification over asset types by investing into different asset types. Holding a portfolio of both stocks and bonds protects your portfolio against major swings in the stock market.
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Most people diversify their assets without themselves knowing it by holding wealth into different accounts and means. Let's say you have an investment account at a broker's office, a savings account and some cash at home. Then your risk is subsequently diversified over those three ways of holding wealth. If your bank goes into default, you still have parts of your wealth.
How much should I diversify?
Is completely up to you. With an appropriate combination of investments in ETF's or broad market indexes, it is possible to diversify so that you are actually copying the market as a whole. But at that level, you will have diversified so much that the advantage of diversification is entirely lost by the magnitude of your diversification.
Many people diversify up to the level where they feel comfortable about. Professional traders and investors will most probably thoroughly scrutinise many assets to come to a proper valuation and will diversify less in order to increase returns. Investors with some expertise, or at least interest in a particular sector, might diversify within sectors and industries. As such they are betting on economic trends of industries as a hole. Examples of this practice includes diversification within emerging markets, or diversification within the technological sector. More passive investors might just let the work be done by professionals, or simply diversify into mutual funds.
Remember from above, if you know what you are doing you can diversify less and pick the winning horses to maximise profits. Diversification is a protection against ignorance.