An interested reader asked TAB this question: ‘Why should we not put all our eggs in one basket, in other words, why should we diversify in Finance?
We had answered a question like this before. So readers of the past string of issues we have been writing on this topic might have inferred that diversification was the basis of most portfolio investment strategy in the management of mutual funds. The key to diversification is that, in finance, it is a risk management technique that advocates the science of investing a portfolio across different asset classes in varying proportions depending on an investor's time horizon, risk tolerance, and goals. Because the fluctuations of a single security have less impact on a diverse portfolio, diversification minimizes the risk from any one investment.
For example, we all know that most investors are notorious for making bad decisions when it comes to investing, oftentimes buying as markets peak and selling as they bottom out (momentum strategy), or doing the opposite (contrarian strategy). What is wrong with these when used as a stand alone strategy instead of in a portfolio, is that, it leads to overexposure to dangerously hot asset classes. And this may simply result to huge losses when these stocks bottom out. Take for instance, if an investor had invested all of his/her wealth in the stocks of Lehman Brothers, a failed bank that was hot just before the financial crisis, say four years ago, by now, the investor would have been reduced to naught/zero.
Diversification provides a framework for rebalancing the portfolio that can help an investor maintain an appropriate level of risk based on their time horizon, goals, and risk tolerance. It does not advocate the intuition of simply buying a stock because is it hot. However, it does not assure or guarantee better performance and cannot eliminate the risk of investment losses. What it does is to focus the investor to a disciplined approach, which helps improve some of the speculation that is often involved with investing.
Diversification reduces portfolio risk or volatility because various asset classes typically perform differently under the same market conditions. For instance, when bonds are up, stocks often tend to be down and vice versa. Also there is an inverse relationship between stock price and the price of gold. By combining asset classes, risk or volatility is reduced. This helps to smooth returns and limit losses due to overexposure to risky market segments. In short, diversification enables the investor to achieve higher returns with less risk. Maintaining a diversified portfolio can help take the guesswork and stress out of managing your assets. Identifying next year’s top and bottom performing asset classes is an extremely difficult task. Following a diversified asset allocation strategy can provide the portfolio with the ability to participate in the top performing asset class while limiting exposure to the worst performing asset class, as they inevitably change. We hope this answers your question.