Diversification: How to Safeguard Your Investments

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Losing even a tiny size of your investments can cause great financial distress. Besides the mental toll it takes, it can result in real-life consequences that may greatly affect your goals.

This is why it's important to invest with safeguards in mind. And in a world with numerous investment options, diversification offers a practical way to do this.

So let’s explore what it is, and why you need it.

What is diversification?

Diversification is the process of investing in a mix of different asset types in order to shield yourself from complete or total loss.

If you are familiar with the phrase ‘Don’t put all your eggs in one basket,’ you already understand what it means. Simply put, diversification means spreading out your risk.

By distributing your investments across various asset types, you benefit in two main ways:

  • You reduce your exposure to losses by owning different and unrelated asset types.
  • You increase your exposure to market gains by owning different and unrelated asset types.

So while diversification does reduce the risk of loss, it also opens you up to other asset types that might be profitable in the long term.

How does diversification achieve safety?

To understand how it works, consider this example:

Suppose that you invested all your money in stocks then the pandemic hits, causing the stock market to slump and start performing poorly. Stock prices begin to fall.

What would happen to the value of your investments?

Well, ALL your returns would get affected. Because your portfolio contained stocks only, it would fall apart entirely. And if the market crashed? The effects would’ve been even worse.

If you had invested everything in real estate and the sector got affected, the results would be the same. You’d make nothing but losses.

But let’s assume that you diversified. You invested part of your money in stocks, part of it in bonds, and what's left in a money market fund. What would happen if the stock market fell?

You’d still have your investments in bonds and the money markets intact.

And what if the bonds market started performing poorly? Your investments in stocks and MMFs would counter the effect of that. By owning different assets at the same time, only a small portion of your wealth would take a hit.

Suggested: How to buy shares in the Kenyan Stock Market

But what happens if all the investments get affected?

Because different assets work differently, it’s nearly impossible for all of them to get affected in the same way, at the same time, by the same economic event.

Take stocks, for example. They are considered to be risky because of their volatility. But bonds, on the other hand, are said to be safe (because the return is ‘more assured’).

So when stocks start to perform poorly, investors shift their resources to buying safer investments. The typical safe investments are usually either bonds or other fixed-income assets. This shift increases the demand for these safer alternatives, thus driving their price (and profitability) up.

The opposite is also true. When stocks perform well, their demand increases since more investors want to benefit from this good performance. This drives the demand for stocks up, taking away interest from bonds and other investments.

Therefore by investing in a mix of assets, you effectively ensure that you are gaining. It won’t matter whether the market sways one way or another.

How do you incorporate diversification into your investments?

Diversification can be achieved in various ways:

  • By buying different types of assets

This involves investing in unrelated asset classes like bonds, stocks, real estate, and fixed-income assets like money market funds. As mentioned earlier, each asset has its own distinct risks and advantages, so what causes a loss in one may cause a gain in another. Therefore, owning assets in multiple asset classes helps to prevent widespread losses across your portfolio.

  • Within the same asset class

In the same way that different assets work differently, so do different sectors. As such, it helps to invest in more than one industry, even within the same asset class. For example, if you’re buying stocks, mix stocks from different industry sectors, like banking, telecommunications, hospitality, etc. If you’re investing in bonds, buy a mix of government and corporate bonds. If it’s real estate, it can be commercial vs residential or I-REITs vs D-REITs.

This ensures that you are not affected by industry-specific risks and that you benefit from widespread industry gains.

Suggested: REITs – How to invest in real estate with little capital

  • Different maturities

Maturity speaks to the duration within which an investment is expected to last and produce its expected return and pay off. In this sense, we have long-term and short-term investments. With bonds, for example, you can invest in either long-term or short-term paper. Across asset types, you can pick between stocks (long-term) and fixed-income options (mid-term). Different maturities have different risk profiles and can be used to offset the amount of risk in your investments.

If you’re a beginning or passive investor…

The best way to achieve diversification is by investing in a mutual fund.

There are three reasons for this:

  • Mutual funds already invest in a variety of assets. And so by investing in an equity fund, for example, you will own a wide selection of stocks in companies across different sectors by default. The same goes for a bond fund or a money market fund.
  • The investments are picked by a qualified professional so you won’t have to do the hard and technical work of research and selection.
  • It is affordable — for as little as KES 500/= you will be invested in 10+ companies. Compare this to someone who invests on their own. It wouldn’t just take too much time, it would also be considerably costly.

Keep in mind that you might need to invest in at least 3 funds, representing each asset class: an equity fund (stocks), a bond fund (bonds), and a fixed-income securities fund (money market). The good thing is that they are affordable and you can start almost immediately.

Protect your downside

The principle of safety in investing is almost akin to a commandment.

Any seasoned investor will tell you this: never lose your capital. This is the single most important rule of investing. And as we’ve just seen, diversification is a reliable way to achieve that.