Diversification is the foundation of a successful investment portfolio. But many people – and particularly first-time investors – fall into the trap of not spreading their risk correctly. Here we unpack why diversifying your portfolio pays off in the long run.

What is diversification?

According to the definitions desk over at Investopedia, diversification is "a risk-management strategy that creates a mix of various investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt to limit exposure to any single asset or risk."

In short? You’re not keeping all your eggs in one basket.

Why diversify?

Why do you invest? To grow your money in as efficient a way as possible. To do that, you have to balance risk and return. You want to get the highest possible return for the minimum amount of risk. People who take on more risk may reap higher rewards than a more cautious investor. Unfortunately, the opposite is also true: if things don't go your way, the higher the risk, the higher the chances of you “losing your shirt”.

First-time investors often make the mistake of not diversifying their investment portfolio, because they focus solely on what they can make and overlook risk management. As a beginner, it's essential to resist the urge to put all your eggs in one basket – even if that metaphorical basket is promising excellent returns.

Suppose you have a couple of thousand rands to invest this year, and you decide to put it all into Amazon (AMZN)  shares. If you have no experience in the stock market, this approach is similar to taking a bet (also known as gambling). The success of your entire portfolio hangs on how well Amazon performs. If, for whatever reason, the share price plunges 50%, your whole portfolio will lose half of its value.

How to spread your risk

Let’s go back to our example. You’ve got a couple thousand to invest, but instead of putting it all into Amazon shares, you split it in half. You invest 50% in Amazon shares and another 50% in Tesla (TSLA).  

Good, you've started to diversify away from Amazon. If Amazon shares fall by 50%, and Tesla shares keep their value, you lose only 25% overall. While this is certainly better than before, it's still not optimal. Your portfolio still hangs on the fate of just two companies.

What's more, Amazon and Tesla are both tech-focused companies in the US, which means they are more likely to react the same to market events. In other words, chances are very high that if Amazon shares fall in price, Tesla shares will go in the same direction.

Uncorrelated assets

Successful diversification relies on creating a portfolio of uncorrelated assets. Uncorrelated assets are investments that react differently to market events. For example, one investment in your portfolio may decrease in value due to a particular event, while another may actually increase in value in response to the same event.

Let's go back to our previous scenario, but instead of investing in Amazon and Tesla, you opt for two uncorrelated options. This time, you put half of your money in Baidu Inc (BIDU), a Chinese internet services platform, and the other half in Kraft Heinz Co, the famous American ketchup company.

Now your assets are very different. Not only are they based in different geographies, but they also have very different business models, so they’ll be affected differently by world events. When consumer spending is low, for instance, Americans will probably still be buying ketchup, even if they put off upgrading their computer software until money isn’t so tight.

Portfolio allocation

We've been dealing with diversification across two shares. But even though they may be uncorrelated, you’re still in a position where if something were to happen to one of them, it will impact half of the value of your portfolio. In order to spread your risk more evenly, you want to spread your investment across more shares.

Now the question is: how many shares or assets should you invest in to achieve the maximum portfolio optimisation?

The short answer is that there is no set number, and even the world’s most celebrated investors disagree on this. Warren Buffett doesn’t believe in diversification; at one point, Berkshire Hathaway had half of its portfolio in Apple shares. That’s pretty much what we’ve just told you not to do, but we’ll allow for the fact that Warren Buffett is ever so slightly better at predicting share prices than you are. In the Bible, King Solomon advised dividing your eggs into seven or eight baskets (he probably didn’t know much about Tesla, but you get the point). Harry Markowitz’s Modern Portfolio Theory (MPT), which is considered a blueprint for diversification, states that beyond the 20th share, the level of portfolio optimisation diminishes.

Thinking outside the shares box

Let’s go another layer deeper, because diversifying your shares alone doesn’t make for a diversified portfolio. There are plenty of assets outside of the stock market that you should invest in too. By combining shares, ETFs, bonds and cash (including forex), you can potentially reduce the overall risk of your portfolio without sacrificing returns. Once your portfolio is nicely diversified and your risk is balanced, you could even look at a few outside-the-box options that are risky but that you take pleasure in, such as property, first-edition comic books or commodities.

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