Diversification: How Smart is your Portfolio?

Diversification: How Smart is your Portfolio?

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Diversification is a common term for most investors. Most of us would agree that diversification is summed up in the phrase “Don’t put all your eggs in one basket.” This phrase may capture the essence on diversification, but it does not divulge into what smart diversification actually is and the phrase certainly doesn’t tell us diversification’s role in an investor’s portfolio.

Is smart diversification investing our money with different investment companies and with different financial advisors? If you looked up the popular equity funds in South Africa, you would probably find that a lot of their top ten holdings are very similar. In fact, six of the top ten shares held by one of the largest fund management companies were also found in the top ten of another popular fund management company.  So is this really diversification?

Although you invested your money with different fund management companies, many of the shares are the same and you could be unintentionally creating a strategy which investment professionals call “closet indexation”. Closet indexation occurs when a fund achieves similar returns to that of an index, but without replicating the index. This is not ideal for investors as we would achieve similar returns to an index but pay higher fees than an index tracking fund.

What is smart diversification?

Smart diversification has to do with creating a portfolio that includes multiple investments in order to reduce volatility. For example, if your portfolio only consists of one share, and that share drops significantly, your portfolio will face the full force of that fall in share price. It would be smarter in this scenario to purchase several shares in different business sectors in order to reduce volatility.

Another way to diversify and reduce volatility in your portfolio is to invest in other asset classes such as bonds, property and cash. The asset allocation of our portfolios should differ due to our time horizon, tolerance of volatility and our investment objectives. An aggressive investor with a long time horizon should have a larger allocation to shares than a conservative investor with a shorter time horizon. This is because shares, although volatile by nature, provide historically the best real returns over the long term.

Regardless of whether we are aggressive or conservative investors, asset allocation is one of the most important decision investors face.

Remember that your personal time horizon, tolerance for volatility and your investment goals should play the major role in determining the appropriate asset allocation to diversify your portfolio to maximise returns whilst minimising volatility. If you are too besieged by the amount of investment options available and/or do not have the time to research the asset classes extensively, speak to a Certified Financial Planner who can assist you in the decision making process.

Andrew Padoa
Andrew Padoa works in the Private Client’s division at Consolidated Financial Planning. His area of expertise is investments, estate planning, retirement planning and portfolio benchmarking. He has had numerous articles published in the media on a number of topics related to personal financial management. Andrew is passionate about educating people and has given several financial literacy talks to both schools and corporates. His objective is to use his abilities and knowledge to help others achieve their financial goals. Visit www.consolidated.co.za for more information
  • ChristoPamGoldingProp2012

    This is a very good article. I think an investment portfolio should be a diverse one as the author has suggested. There are almost infinite opportunities with property now, which should be considered. There are neighbourhoods inside the N1 highway ring which are not saturated and fully developed and that have numerous options for living, business, and commercial use. The properties in these areas are much more affordable and the prospective owner and/or investor will receive value for money.

  • I agree with this article.Yes asset allocation is one of the most important areas an investor should consider when investing .However, for entreprenuers not all of us have access to investing in property and to be honest I don’t consider investing in bonds necessary for an entreprenuer .Institutional investors can find bonds a good part of any portfolio but for the majority of us we stick to equity and equity remains one of the few options left to the small investor .We are all primarily investors thats why we are entreprenuers ( investing in our companies ,right ) . The questions then should be how should an entreprenuer invest ,how should he deal with capital preservation and how should he invest his profits which are he/she has not injected back into the business ? wwwdanolusresearch.blogspot.com.