Diversification is Key

When it comes to your investments and wealth, do you tend to have all your eggs in one basket?  Through out this investment series we’ve looked at the different types of stocks and fund managers.  Now we’re going to look at the mix of your investment and how it relates to your risk and return.

Risk can be broadly classified in two ways:

• loss of capital and• loss of purchasing power

Loss of capital comes from investing in securities whose value fluctuates due to systematic risk, unsystematic risk, or both. Non-systematic risk is the risk associated with one individual shareholding. Because the risk can be easily eliminated with diversification, the market does not reward investors with a return premium for this type of risk. So, when investors concentrate their investments they are increasing their risk with no added benefit of higher expected return. Systematic risk, on the other hand, cannot be diversified away as it is the risk common to the market as a whole. Investors require an extra return – known as the risk premium – to bear this risk.

Diversification in investing refers to the process of spreading out risk. The most prudent approach to minimise risk and maximise the probability of achieving a market rate of return is to hold the entire index. In this way the specific risk of holding each individual stock within the index is diversified down to near zero leaving investors with the systematic risk of the market the index is designed to track.

Global diversification is beneficial because it applies the same rationale as above. There are now more risk factors in international markets that can both smooth out volatility and increase expected returns. For example, in 1970 the United States represented 68% of world market capitalisation whereas Asia represented just 7%. By 2004, the United States’ share had decreased to 46%, whereas Asia had increased to 22%. Clearly, investors cannot ignore the global dimension in constructing portfolios.

The three factors or dimensions that explain equity market risk and return (market, size and value) are clearly observable in international markets, as shown in the illustrations below:

Small & Large StocksIn the next post we’ll be looking at investing outside of the markets.  If you don’t want to miss out on your future posts, sign up to our newsletter and they’ll pop up in your inbox without you having to think about it.