Investment lingo can often be complicated and leave you feeling confused and unsure of what to do. Let’s look at what it means to diversify your investments, and why it’s so important to do so.
We’ll use farming as an analogy to explain the concept and use Mr Farmer as an example. He has ample land to use and decides to plant only wheat. There are great profits to be made, but the risk is quite high. Adverse weather conditions, insects or wheat-related disease could wipe out the entire crop. Or perhaps the wheat market changes in a particular year and Mr Farmer struggles to sell his produce for a good price.
However, if Mr Farmer uses 50% of his land for wheat and the remaining land for a different grain, he will reduce his risk. If one crop fails, at least there is the other one to fall back on.
However, one could diversify even further by allocating some land to grains and pulses, some to vegetables, and some to fruit and even livestock. The more ways you utilise your land, the better chance you have of succeeding over the long term.
Drought, disease and natural disasters will have greater effect on some aspects of the farm than on others, and things will even out.
Taking this even further, farming itself is rather risky, so it would be even better if Mr Farmer also had other investments. One can diversify within your chosen asset class (such as agriculture), and one can diversify across asset classes and have investments in property, shares and precious metals, for example.
Diversification is all about spreading your bets and lowering your risk.
If we look specifically at shares, the same principle applies. You may put all your money into a high-performing company and make great returns each year. However, we don’t know the inside dealings of companies and thus don’t really understand the risk. Take the recent downfall of Steinhoff as an example – if you had placed all your investments in those shares, you would be in a very poor position now.
A better way to invest is to spread your money across multiple companies and across multiple industries. You won’t take such a big knock when an individual company performs poorly as others in your portfolio may be doing well, so you will essentially get the average growth of all the companies you are invested in.
You could create your own investment strategy and decide how to allocate your investment across companies, however, this is a guessing game unless you have a strong financial background – it’s not easy to research and monitor 20 or 30 companies to keep track of their dealings.
Other options to diversify your portfolio would be to use a standard product created by a financial institution. Most investment companies offer a balanced portfolio product that comprises different asset classes (shares and cash) across multiple companies and sectors. They all offer a multitude of products to choose from. Such managed products allow you to piggyback on the expertise of fund managers. Unfortunately, you will pay relatively high fees for this and it’s definitely worth comparing costs before committing to any product.
Exchange-traded funds (ETFs) are a much cheaper way to invest in a basket of shares. This is often called “passive investing” because ETFs require little management, so fund managers can charge significantly lower fees.
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An ETF could, for example, track the Top 40 index, which is a weighted average of the top 40 companies listed on the JSE. If you invest in an ETF, you aren’t actually buying shares in each of the 40 companies – you’re buying a product that mimics the performance of the Top 40 index. It may sound strange, but it’s cheaper than actually buying shares in all the individual companies, and obviously a lot less admin. Each trade you make incurs a cost, so the fewer trades you make (and the fewer made on your behalf), the less it costs.
Having an ETF does not replicate a balanced fund in terms of diversification of assets, but you could create your own portfolio comprising a few ETFs. It’s also interesting to note that some ETF platforms offer low-fee unit trust balanced funds. These are easy to invest in and offer a good level of diversification. Satrix and CoreShares are two examples to look at.
Whatever your preferred asset class, country or industry, make sure you spread your investments.