Why should I diversify my investments?

Key takeaways

  • Diversification means you don’t put all your investment eggs in one basket – rather you spread your money across securities, market sectors, regions, asset classes and even managers.
  • If one of these factors to which you are exposed in a well-diversified portfolio performs poorly, the performance of the others should reduce the overall impact.
  • Diversification along with time in the market and compounding, are the three keys to success as a long-term investor.
  • Collective investments, such as unit trusts and exchange traded funds, offer an affordable, professionally managed diversified investment.


The proverb “Don’t put all your eggs in one basket” sums up the reason why you should diversify your investments.

The benefits of diversification, time in the market and compounding are the three keys to success as a long-term investor.

Diversification and time in the market both allow you to manage investment risk.

Instead of investing in a single share, bond or other security, investing in one sector of the market, in one asset class or in a single country or region, you diversify across a number of different securities, market sectors, asset classes and regions.

The principle is if you invest in a single investment, for example, a single share, your risk of that share giving you a poor return is high. Even if you have heard good things about the company and are expecting the share to do well, you cannot foresee the future and what may happen.

There are cases of what appear to be good companies being rocked by scandals or losing their competitive edge.

If you could foresee the future, you could pick the best share and only invest in it for the highest returns.

But since no one has this perfect foresight, diversification is the way to avoid the risks concentrated in one investment and can enhance your returns.

When you diversify across a number of shares, the risks each company faces are different and the impact will be less severe if one fails, but the others do well. You may not earn the return of the best-performing investment, but you will avoid the losses of the worst-performing one.

Over time, a well-diversified portfolio will outperform most, but possibly not all, portfolios that are highly concentrated in a single, or few, investments. Being able to identify the few that will outperform, however, is what is difficult and can lead to wrong calls.

The key to being well diversified is to have investments that do not perform in the same way. Investment managers say you should look for investments that are not correlated.


Ways in which you can diversify

Across asset classes

Investing in asset classes with different risks and returns, can give you diversification.

Shares and bonds, for example, do not deliver similar returns for most of the time, although there can be periods when both gain or lose.

Adding other asset classes, such as listed property, cash, commodities and alternative investments such as hedge funds or private equity, can give you greater diversification.

If you consider the annual returns of the different asset classes over a period years, you will see there is no consistency in the performance of the different asset classes. Managers make calls on which asset classes are likely to perform best in future, but holding some of each can protect you against a wrong call. 

 

Across industries and sectors

Shares on the stock market are classified by industry or sector. Investing across a number of sectors, will give you diversification across the different industries, such as financials, industrials, mining and resources, communications, healthcare, technology and real estate.

If you want exposure to shares on the JSE, investing in a unit trust like an equity general fund, or an exchange traded fund that tracks the All Share index, will give you this sector diversification.

You can get even greater diversification if you invest in a bigger market, such as that of the shares listed on stock exchanges in the United States, or shares listed on major stock exchanges around the world. This will give you exposure to industries that are not found in South Africa.

 

Investing across company sizes

Investing across shares that are classified as small, mid and large capitalisation shares is another way of diversifying. The capitalisation of a share is the price of it multiplied by the number of shares in issue at any point in time.

Larger companies’ shares not only cost more, but the company can issue more of them. Larger shares in South Africa tend to be those that earn money by exporting or selling goods and services in foreign markets. As a result, their profits are influence by other economies and are less reliant on what is happening locally. Their rand returns are also influenced by the performance of the rand – when the rand weakens relative to the currency in which the company earns its profits, these companies do well.

Small and mid-cap shares are often shares that make their money in the local economy. This makes the returns from these shares different from those of larger shares.

Small cap shares are generally higher risk, but with potentially higher returns.

 

Investing across countries and regions

Investing in other countries is another way to diversify your investments.

In particular, investing across developed or emerging markets gives you diversification.

South Africa is classified as an emerging market country and the performance of the local share market is often in line with that of the share markets in other emerging market countries.

 

Investing across manager styles

You can also diversify your investments by spreading them among managers with different investment styles that are expected to deliver good returns at different times.

Using more than one manager won’t necessarily give you good diversification if the managers you choose all have similar styles and invest in similar shares or other securities.

South African managers style of investing may be one of value investing, valuation-based investing, growth investing or momentum investing. Some prefer large market capitalisation or large cap shares, some prefer mid-cap shares and small cap shares. Some large managers are forced to invest only in larger shares, while boutique managers can invest to a greater extent in small and mid-caps.

Some managers invest in line with their benchmark – they take smaller bets on larger or smaller allocations to a share or other security than is in the benchmark. Other managers are benchmark agnostic and invest in whichever security they believe will deliver regardless of how it is represented in the benchmark.

Investing with managers with different approaches can give you greater diversification than investing with a single manager, or more than one manager with the same approach.

 

Into alternative asset classes

Investing in alternative asset classes such as hedge funds, private equity, real estate, commodities or even cryptocurrencies, can give you a greater diversity than if you invest only in the traditional asset classes of shares, bonds, listed property and cash.

Investment tip

An easy and affordable way to get good diversification is to invest in a unit trust or exchange traded fund.

Your retirement savings must be diversified in line with the guidelines in Regulation 28 of the Pension Funds Act. If you have the option to choose your own retirement fund investments they should either be funds that comply with the regulation or you will need to ensure that your choice of funds collectively complies with the regulation.