What diversification really means

Investment portfolios are like teams.  They should all work together harmoniously, with each member bringing their own strengths to balance out the others’ weaknesses so that no matter what happens, you wind up with a good result.  That’s the theory.  The art, science and skill of diversification is building an investment portfolio which makes this work in practice.  Here is a quick guide to some points you may wish to consider.

Capital appreciation versus income

Capital appreciation will increase the overall value of your portfolio but you will only realise this value when you sell your shares.  Income-producing assets provide cash which you can either reinvest or use for your living expenses.  The extent to which your portfolio is weighted towards one or the other (or perfectly balanced between them both) will depend on a number of factors, such as your investment horizon. 

For example, if you are at the start of your working life, then you may be quite happy to let the value of your portfolio grow, perhaps so that you can cash (part of) it in to pay for life events such as a house purchase.  If, however, you are heading towards retirement, then you may need to think about replacing your current income, but you may also need to think about continuing to grow your portfolio for the decades which might still lie ahead of you.

When considering this point, it’s worth noting that some asset classes can switch between one form and the other.  For example, if you invest in a start-up, you may see the capital value of your shares grow as the company matures but it may be some time before it starts to pay a dividend and when it does its rate of growth may slow as it uses up some of its capital to reward its investors instead of fuelling its expansion.

Risk level

Risk is an interesting concept and it’s not always as clear-cut as it may appear.  For example, cash deposits and bonds may initially appear very low risk because you are guaranteed to keep your capital intact and see a return from it.  Shares, by contrast, may seem higher risk, because their performance reflects a company’s success and if the company does badly you may start by losing your dividend and end by losing your capital. 

At the same time, however, the returns from cash deposits and bonds are only guaranteed if the borrower can actually meet their obligations.  If they can’t e.g. they go out of business, then bondholders will simply have a proportionate claim on the borrower’s assets (if any).  Even if the bondholder does make good on their obligation, the returns from bonds may not keep place with inflation, meaning that your capital will, effectively, be eroded, while the returns from stocks can, in principle, be limitless, at least enough to keep pace with or even outpace inflation. 

In short, a portfolio which is weighted too heavily towards “safe” assets may wind up not generating sufficient returns to keep pace with inflation whereas a portfolio which is weighted too heavily towards “risky” assets may crash and burn.

Younger sectors/locations versus mature sectors/locations

In a way, this point reflects both of the previous points.  Young sectors and locations (emerging markets) can have a lot of room to grow, but this means that investors may need to exercise patience when waiting for their returns and they may also need to accept that something may go wrong during the growth period which would reduce (or even cancel out) the returns they expected.  By contrast, mature sectors and locations (developed markets) may have less room to grow, but their established position may give them a greater degree of stability and strength, especially in challenging times.