What is diversification?
Diversification means spreading money across different investments to reduce risk. The old saying sums it up: don’t put all your eggs in one basket. If one company, one sector or one institution runs into trouble, the others may still be fine.
The key is choosing things that do not move in the same direction at the same time. When one does badly, another does well or at least holds steady. So the ups and downs of your total money shrink, even if any single part swings a lot on its own.
Say Mr Mizan has a small shop on the corner. If he sells only umbrellas, he earns well in the monsoon but almost nothing in the dry months. If he sells only sherbet, he does well in the heat and badly in the rain. Selling both keeps his income far steadier through the year, because one sells when the other does not. Diversification works the same way with investments. The person is made up.
Why it matters to an investor
- To limit the cost of one mistake: even if one investment fails completely, it is only part of your savings.
- To stay calm: when your total swings less, you are less likely to make panicky decisions in bad times.
- To be ready without knowing the future: nobody knows for sure which sector or asset will do well next. Spreading your money is a way of admitting that.
- To cut risk at little cost: done well, it reduces risk without giving up much expected return.
Which risks it reduces, and which it does not
Risk comes in two parts. One is the risk of a particular company or sector: poor management, fraud, demand for one product drying up. Diversification can reduce much of this, because it does not happen to every company at once.
The other is market-wide risk: a recession, rising interest rates, a fall across the whole share market. However many shares you buy within the same market, you cannot fully escape it. That is why spreading across different kinds of assets (shares, bonds, deposits, gold) is talked about, not just owning many shares.
How much is enough, and false diversification
- How much: the investor guide from the US regulator, the SEC, says you need at least a dozen carefully chosen individual shares to be truly diversified with shares alone. Mutual funds hold many shares at once, which makes this easier with small amounts.
- Many shares in one sector: five different companies, but all in the same sector, can all fall on one piece of bad news for that sector.
- Several wrappers around the same thing: you buy several funds, but they all hold much the same shares. It looks spread out, but it is the same basket.
- Tied to your own income: if you work for an organisation and also keep most of your savings with it, one problem puts your job and your savings at risk together.
At the US energy company Enron, about 62% of the employees’ retirement savings plan (a 401(k)) was in Enron’s own shares (at the end of 2000). Shares that were around $90 in August 2000 fell below $5 by November 2001, and the company went bankrupt. Many employees lost their jobs and their retirement savings at the same time.
Worked example
- Say you have Tk 1,00,000. In the first case you put it all into one company’s shares. In the second you put Tk 20,000 each into five companies in five different sectors.
- One company runs into serious trouble and its share price falls 50%. Assume the others stay the same.
- In the first case you lose Tk 50,000, or 50% of everything. In the second you lose 50% of Tk 20,000 = Tk 10,000, or 10% of everything.
Result: the same bad news, but a fifth of the damage. Remember, though, that if the whole market falls, all five can fall together; that is why spreading across types of asset matters too. The numbers are only an example.
See the numbers as a table
| Total loss | |
|---|---|
| All in one company | 50% |
| Split across five | 10% |
Common mistakes
- Buying lots of shares and thinking you are diversified when they are all in the same sector.
- Thinking diversification removes all risk. It cannot protect you from a fall across the whole market.
- Putting money into something you don’t understand, or that is unlicensed, just “to spread it out”.
- Spreading so thinly across so many things that you lose track of why each is there and what the fees add up to.
Spread your money across things that do not all go wrong together; owning more things is not, on its own, diversification.