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The times are tough now, they’re just getting tougher. So why is diversification important?
I have heard many people talk about the importance of diversification. Sometimes when I have asked them how they have diversified their wealth to reduce risk, some of the responses indicate that there is a real lack of understanding out there about diversification.
Firstly, let’s look at the definition of diversification. Broadly, diversification is defined as “the action of making or becoming more diverse or varied”. When you focus on investment it is defined as “a technique that reduces risk by allocating investments among various financial instruments, industries and other categories.”
Some of the replies I have had over the years to my question above include:
“I have spread my money amongst the banks and finance companies”
“I have property spread across the country”
“I own residential and commercial property”
“I own about 10 shares in different companies on the NZX”
“My money is safe, it is in the bank”
Ok. So, let’s identify some of the risks that can occur when you invest.
- The company you invest in can fail. This includes private companies and banks as we have seen here in New Zealand with BNZ coming close in the late eighties and we saw recently in the US in the Global Financial Crisis. We also saw the failure of many finance companies in New Zealand at the same time.
- The asset class you invest in suffers because of broad macroeconomic factors. These factors include things like unemployment, immigration, savings, inflation which affect supply and demand. Now, in Auckland we are seeing huge demand for property due to population increases, low interest rates and a lack of supply.
- You also face the risk of missed opportunities. No one knows which asset class (shares, property, cash) industry or country for that matter will deliver the strongest performance in any given year. Just owning New Zealand shares means that you may have a bumper year one year. The next year could see American shares deliver the best performance and New Zealand shares deliver a negative performance.
- As mentioned in point 3, New Zealand shares may outperform other asset classes one year and then bomb the next. This causes a wider variance in returns year on year for you. Over a 5-year period this may deliver the same arithmetic return (the average return) as a broadly diversified portfolio. You may ask so what’s the problem? The problem is your compound return over the period. This is illustrated for you in the table below. Compound return is the rate of return that represents the cumulative effect that a series of gains or losses have on an original amount of cash over a period of time. It is the return you get on your return.
The returns in this table are hypothetical to focus on the importance of compounding returns.
| Year | Rate of Return | Ending Value | Rate Of Return | Ending Value |
| 1 | 8% | $108,000 | 30% | $130,000 |
| 2 | 8% | $116,640 | -20% | $104,000 |
| 3 | 8% | $125,971 | 25% | $130,000 |
| 4 | 8% | $136,049 | -20% | $104,000 |
| 5 | 8% | $146,933 | 25% | $130,000 |
| Arithmetic Return | 8% | 8% | ||
| Compound Return | 8% | 5.39% |
- The risk that the money you are counting on to purchase something important or sustain your lifestyle at some point in the future won’t be there when you need it. Investing in just cash may not deliver the growth that you require to maintain your lifestyle. Inflation may erode your wealth.
So, in summary:
- Diversification removes unnecessary risk of holding one share
- Diversification reduces the impact of any one company’s performance on your wealth
- Attempting to identify a group of future winners is a guessing game
- Diversification improves the odds of holding the best performers
- By holding a globally diversified portfolio, investors are positioned to capture returns wherever they occur
- A well-diversified portfolio can provide for a more stable outcome than investing in a single security or asset class
- Diversification, over time, has historically provided capital growth that exceeds inflation
Do any of you resonate with any of those comments I have heard in the past from clients?
To discuss any of the information presented above or if you would like a free consultation or second opinion on your wealth portfolio, please feel free to get in touch. You can call me on 021414755 or email me at zn.oc1611100090.rets1611100090ibsi@1611100090ttam1611100090
- Posted by Isbister
- On January 30, 2017