Expats and global citizens alike often work in multiple countries over the course of their professional lives. It is vital to ensure that investments are not just country-specific, where there is a higher risk of loss, but diversified to spread the risk.
What is Diversification?
Financial diversification is an investment strategy that involves spreading your investments across different types of assets, industries, sectors, or geographic regions to reduce risk. The idea is to own a variety of investments with different characteristics, with the purpose of reducing volatility. The basic idea is:
“Don’t put all your eggs in one basket.” Why Diversify?
1. Reduce Risk
If one investment performs poorly, others may perform better, helping to balance your overall returns.
2. Protect Against Volatility
Different assets react differently to economic events. For example, stocks may fall while bonds or gold rise.
3. Smoother Returns
Diversification helps you avoid big swings in your portfolio’s value over time.
Ways to Diversify
Diversification can be divided into various asset classes, sectors and geographic regions.
1. Asset classes
Diversifying across various
asset classes is an excellent way to spread risk in a portfolio. A fund manager would determine the percentage of asset classes in a portfolio according to a risk profile. Factors that may negatively influence one asset may benefit another. This helps spread the risk of the portfolio.
Types of Asset Classes
- Equities or stocks are typically stocks of companies. They generally have a higher risk but also a higher return potential.
- Bonds are government and corporate fixed-income debt. They are generally more stable risk investments with guaranteed fixed returns, albeit lower than equities. An investor nearing retirement, usually invests in more bonds to reduce risk and preserve capital.
- Cash includes treasury bills, money market solutions and other low-risk investments.
- Real Estate could include commercial and residential properties.
- Commodities like gold, maize, wheat, sugar, natural gas, etc.
There can also be diversification within asset classes according to the size of the company, namely large, mid and small-cap companies.
2. Sectors
This method of diversification spreads investments over sectors. Sectors or industries operate differently from each other and react differently to markets. Investments diversified across industries are less likely to be impacted by sector-specific risk.
Sectors include:
- Information technology (Meta, Nvidia, Apple, Microsoft, etc.),
- Healthcare (Johnson & Johnson, Pfizer, etc.),
- Financials (banks, financial services, etc.),
- Consumer discretionary (hotels, restaurants, entertainment, vehicles, etc.),
- Communication services (telephone and internet providers, Disney, Netflix, etc.),
- Industrials (transportation, airlines, construction, aerospace, manufacturing, etc.),
- Consumer staples (Nestle, Coca-Cola, Unilever, etc.),
- Energy (wind, renewable energy, fossil fuels, etc.),
- Utilities (electricity, water, sewage removal, etc.),
- Real estate (property management, land, commercial, industrial, residential, etc.) and
- Materials (mining, forestry, etc.).
3. Geographic Regions
This means holding investments from different regions.
As an investor, you don’t want all your money in one country or region in case of failure. Spreading investments across various regions allows you to reduce portfolio risk by avoiding overconcentration in one area.
Regions include:
- US
- North America
- South America
- Africa
- Europe, as a whole or including individual countries like the UK or Germany.
- Asia
- Middle East
- Australasia
Example of Geographic Diversification
For example, a portfolio that invests heavily in Asia may suffer significant losses if China or Japan’s economy were to go into a recession, while including the US and Europe in the portfolio would allow for more stability.
Economic Stability Across Different Regions
Some regions are more economically stable than others. The US and European economies are more reliable and historically stable, whilst emerging Asian, African and Latin American markets are still volatile.
How does Diversification protect your Investments against Market Volatility?
- In layman’s terms, it means not carrying all your invested “eggs” in one basket. By holding several baskets of eggs, you are spreading the risk of losses if one basket falls.
- Diversification is an important risk management strategy that reduces a portfolio’s volatility while not compromising profits.
- It’s not just about choosing a mix of assets, sectors or regions. A portfolio manager looks at the kinds of companies in the asset classes, sectors and regions.
- Some companies are in their high-growth phase and tend to be newer companies that could offer different risk and return characteristics than older, more established companies. These companies generally have higher valuations and higher returns, e.g. Nvidia. Value companies have slower growth and are more established, but offer more stability.
- In asset classes, the equities class have a higher potential for growth but also a higher risk factor, while bonds are more stable and offer lower fixed returns. A higher equity percentage in a portfolio means the investor wants to grow their portfolio and is prepared for higher risk to get higher returns. A portfolio with fewer equities and more bonds might mean investors want to preserve their capital.
- Often, a younger investor will have higher equities to grow their portfolio. An older investor might prefer to preserve the capital they have accumulated for retirement.
- A portfolio manager will look at an investor’s risk profile and select funds accordingly. Higher risk means investing more in equities that are performing well, like companies in the big tech, financial, and energy sectors.
- These diversification strategies are designed to lower a portfolio’s overall risk against market volatility and global uncertainty. This long-term strategy will smooth out the ups and downs in a portfolio caused by volatility while offering good long-term returns.
Diversification doesn’t guarantee profits or fully eliminate losses, but it helps manage risk in uncertain markets.
