As an investor, diversification should not only be your friend but your very good friend. It is very crucial to understand the importance of diversification in your investing journey since risk is a huge part of investments due to the volatility and unpredictability nature of markets.
So, what is diversification and why is it important? DIVERSIFICATION can be defined as spreading your risk across different types of investments. In simpler terms not putting all your eggs in one basket. For example, instead of investing in only shares, you can invest in shares, bonds, and REITS. By diversifying your portfolio, you reduce the consequences of a wrong forecast as it is assumed not all investments will be doing badly at the same time. It’s like in sports betting, since you are not 100% sure which side will win, you bet on them both.
The major sources of risk in investing can be either systematic or unsystematic. Systematic risk is the risk that affects the entire market. In most cases this risk is not diversifiable however if you have deep pockets you can diversify by investing in different markets. E.g. in 2007 when Kenya was experiencing post-election violence, the entire market plunged down, the Kenyan market was not desirable for investments. Only those with offshore investments were at an advantage.
On the other hand, unsystematic risk is the risk that is specific to a company or an industry and can be drastically reduced through diversification. E.g. when the interest rate cap was introduced in 2016, the banking industry took a huge hit. If you only held stocks in banks, your portfolio would have significantly reduced in value or if you needed to sell your shares at the time, you may have been forced to sell at a loss. However, if you had diversified, the other stocks you held should still have been performing well and in case you needed to sell, you could have sold those as you waited for the bank stocks to re-stabilize.
Apart from minimizing risk of loss, diversification will assist you to generate income in different ways. A well-diversified portfolio should offer different sources of income. E.g. If you hold a portfolio with stocks, bonds and real estate, you will have different sources of income which in most cases be paid out at different times. You can earn dividends and/or capital gains from the shares, while still earning interest from bonds and rental income and/or capital gains from real estate. This is important as sometimes investments don’t always perform as expected and by diversifying you will not merely relying upon one source for income.
I know diversification can sound difficult to achieve for those starting out, however you need not to worry. As a beginner, you don’t have to start by buying different investment options in all sectors as this can be quite capital intensive. There are products in the market that are already diversified in nature. A good example is mutual funds. In most cases a mutual fund will have diversified portfolio therefore you will be buying a piece of the diversified portfolio. E.g., if you buy into a money market fund, the fund would probably have invested in a mix of short-term investments such as fixed deposits, treasury bills, commercial paper etc. You will be buying a section of each of those investments.
PS. None of this content is financial or investment advice. It’s for educational purposes only. Please do your own research and/or consult with a professional if you want advice customized to your specific situation.
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