One Important Investing Principle - Diversification

Investors who have dipped their toes in the market would probably heard of this investing adage plenty of times:

Don't put all your eggs in one basket.

In simple terms, it means one should constantly look to diversify his portfolio and reduce the risks.

Why is Diversification important?

Although it may sound like a broken record, diversification is important simply because it helps to spread out and lower your risks.

This is based upon the notion that any one investment or venture could fail. This applies to even “can’t fail” companies. No matter how safe you think an investment is, you could potentially lose it all if you invest your entire life savings into it.

One recent example is First REIT (AW9U.SI).

Once hailed as a low risk REIT with stable hospital assets, First REIT’s share price has plunged more than 80% from S$1.40 in Jan 2018 to S$0.23 as of 29 Dec 2020. While many investors may not have expected this crash to happen, the message is clear – diversification protects you from losing your shirt even if one investment among your whole portfolio turns sour.

3 Ways to Diversify

There are plenty of ways to go about portfolio diversification and here are 3 possible ways of how investors can do it.

Diversifying by Asset Classes

A traditional method taught by schools is to split the portfolio between stocks and bonds.

The reason is that stocks are more volatile or risky whereas bonds are more stable. On the flip side, stocks can lead to larger returns over time and bonds typically have much less financial upside. Hence, they blend well together as a simple way to diversify the portfolio.

Other asset classes which can be thrown into the mix include financial investments like gold, real estate, commodities and even cryptocurrencies. But investors would have to evaluate the different risk profiles based on your investment objectives.

Diversifying across Industries

Although one can simply diversify by buying into as many investments as possible, it is still vital to find the balance across multiple industries.

For example, if one is heavily vested in the REITs sector, he should also look towards other non-property industries.

One main reason for doing so is that if you buy into 20 different oil-related stocks (such as KeppelCorp and Rex International), an oil price plunge would affect them all as a whole.

Diversifying through Time

The famous maxim of "buy low, sell high" is sometimes easier said than done because no one can really predict the exact peaks and troughs of stock markets.

That said, investors can utilize this concept of diversification through time, or also known as dollar cost averaging.

It is a simple and effective strategy that advocates investing smaller sums of money into the stocks on a regular basis. By doing so, it helps investors to partake in stocks investing and at the same time, removes the emotional stress of timing the markets.

Beware Pitfalls of Diversification

Despite the strong proponent of diversification, investors should bear in mind that diversification isn’t fool proof — because investing itself comes with risks and no strategy will eliminate that.

The recent pandemic is a classic example – global stocks are all plummeting during March 2020 as Covid-19 strikes fear into the whole world.

Another point to take note of, is that ‘over-diversifying’ can lead to meagre returns and excessive trading costs if one is not careful enough.

Conclusion

To conclude, diversification is a fundamental principle of investing because it helps you grow your portfolio and protect it at the same time. That said, although diversification usually make sense for most people, one should also be smart about it and not make all decisions with an obsession to stay perfectly diversified.

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