What is diversification? Diversification is a strategy that can be summed up by the adage ‘Don’t put all your eggs in one basket.’ The strategy involves spreading your money among various investments such that if one investment loses money, the other investments will more than make up for those losses.
An investor can protect his/her investment against significant losses by including asset categories with returns that move up and down under different market conditions. Historically, the returns of the three major asset categories have not moved up and down at the same time.
Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns, i.e., inflation, interest rates, etc. By investing in more than one asset and/or one asset category, you’ll reduce the risk that you’ll lose money and your portfolio’s overall investment returns will have a smoother ride.
Connection between asset allocation and diversification.
Asset allocation is a medium investors use to diversify their investments among asset categories. A diversified portfolio should be diversified between asset , i.e., stocks, bonds and cash equivalent, and within asset categories, i.e., between banking, building materials, petroleum marketing sector for stocks and same for other asset categories. In addition to allocating your investments among stocks, bonds, cash equivalents, and possibly other asset categories, there is need to spread out your investments in segments of each asset category that may perform differently under different market conditions. However, never diversify for the sake of diversification.
How to achieve diversification
Achieving diversification can be challenging. By investing in more than one asset category, i.e., cash, bonds, property, shares, etc, an investor can diversify his/her portfolio. Also, investing in more than one sector within an asset category, i.e., buying a government, state or corporate bond or buying stocks within the banking, building material, food and beverage, etc, sectors can also lead to diversification.
However, some investors find it easier to diversify within each asset category through ownership of Mutual Funds rather than through individual investments from each asset category.
What is a Mutual Fund? Mutual Fund is an investment vehicle that pools money from many investors and invest the money in stocks, bonds and other financial instruments as allowed by the fund asset allocation.
For example, the FBN Heritage Mutual Fund is a mutual fund that is allowed to invest in stocks, bonds, money market instruments and real estate. A unit holder of the fund will have successfully diversified his/her investment.
Mutual Funds make it easy for investors to own a small portion of many investments. Mutual Funds have been a popular investment vehicle for investors. Their simplicity along with other attributes provide great benefit to investors with limited knowledge, time and money.
Advantages of investing in a mutual fund:
Diversification: For an individual to achieve a truly diversified portfolio, he/she may have to buy stocks from different capitalisation from different industries and bonds with varying maturities from different users. For an individual, this can be quite costly. However, by purchasing mutual funds, the individual is provided the benefit of instant diversification and asset allocation without the large amounts of cash needed to create individual portfolios.
Economies of scale: The easiest way to understand economies of scale is by thinking about volume discount. If only one security is bought at a time, the transaction fee will be relatively high. On the other hand, mutual funds are able to take advantage of their buying and selling size to reduce transaction cost.
Oyebola is the managing director, FBN Ca