Diversification: A big word for spreading your bets

On not putting all your eggs in one basket.

Diversification: A big word for spreading your bets

Why are we having this discussion?

Now that you understand asset classes and that each one has its own set of risks and returns, you can apply a diversified approach to investing which can help you maintain a less volatile investment portfolio as well as potentially earn better returns.

Vola-wha?

Volatility is just a fancier way of saying ‘ups & downs’. When share prices go up and down a lot, it can be said that the price is volatile. One rand is always worth one rand, in which case the price of a rand is not volatile at all. Some asset classes are more volatile than others.

Is “Risk” your middle name?

Diversification is really about juggling risk and the potential for reward. You could go ‘all-in’ and only buy shares. Your expectations may then be that of higher returns over the longer-run, but remember that shares typically experience the most volatility. Maybe you like the idea of higher returns, but cannot tolerate the ups and downs.

Are you safe as houses?

Alternatively, you might be totally risk averse and be largely intolerant of losses in the value of your investments. You may need the money in a few years’ time as a deposit on a house, and cannot stomach large dips in value.

This however comes with the caveat that low volatility asset classes, typically don’t provide the larger returns one can expect with more volatile asset classes.

But why are shares more risky than other asset classes?

This is because shareholders are the first to realise a loss arising from the underlying business, and bond holders are last. This all comes back to risk/reward payoff. Investing in someone else’s business is risky stuff – there are many things that could go wrong.

For this risk, you’re compensated by way of a share in the future profits of the company. Debt holders on the other hand are far more secure and don’t necessarily lose money if the business does badly; they are paid their interest either way.

But how do I know whether I can tolerate volatility or not?

This is a good question and best answered by understanding that all investing should be goal-orientated. By investing towards a specific objective, you’ll be guided as to what your tolerance for volatility is. If you’re making monthly debit orders for your retirement savings that you’ll only need in about 20 or 30 years’ time, history suggests that your tolerance for volatility is much higher and you’ll accordingly be able to invest in riskier assets. Riskier assets mean the prospect for a higher investment return.

If, however, you are saving for a deposit on your first house and you know how much you’ll need in 24 months’ time, seeing your savings value drop unexpectedly won’t help you when you need to pay over your deposit. You’re then less able to endure volatility and would need to consider holding fewer shares and more stable assets, but appreciate then that the prospect for higher returns is similarly limited.

It’s give and take; a bit of potential return for less volatility.

Isn’t there a risk-free way to make more money?

Nobody wants to lose money, so why don’t we all invest in cash? After all, one rand will always be worth one rand.

Well the reason is as follows: For low volatility, you get low returns. If your motives are short term, this may work for you, however if you are investing for the long haul (like all of us need to do), you will not get adequate returns on your low volatility assets that will see you earn a real return. Remember that a real return is crucial for long-term wealth generation.

As you’re hopefully starting to see, ‘volatility’ is a risk that we have to expect should we be in search of adequate returns. Like one does with all risk, we do our best to mitigate it. What our investment returns then look like over time is really then largely a product of the mixture of our assets classes. It is this mixture that to a very large degree is responsible for the return on your diversified portfolio.

OK, so how do I diversify?

We’re talking about diversification in the simplest sense, which is a diversified holding across asset classes; spreading your investments across shares, bonds, cash and property. Not all may be appropriate for you, but holding a basket of different assets will ensure that you participate in the stronger performing asset classes, while also protecting yourself from any poor or negative performance in others.

As you start to learn more about investing and where you could invest your money, be aware of what asset class you’re investing in. Each presents its own very specific return profile. A return profile is the type of return one can expect from the asset class, as well as how often you might get that return and what the volatility looks like.

If you engage the services of a financial advisor to help you start investing, have them explain what you’re investing in and how that asset class generally behaves over time.

Conclusion

Diversification is not an insurance policy against all loss. It is however, a strategy that can guard against needlessly large losses. Even if you’re comfortable with risk, we at WellSpent recommend you diversify your investments, spread the risk, and get rich slowly.

The Editors

 

 

People who Rock

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