Diversification can be considered as a major important aspect of personal finance and investment. Even though it has received some criticisms from a few noted investors and financial analysts, the positive outcomes of it is still emphasised globally.
This has therefore drawn the interest of many personal finance writers and bloggers to include diversification in their topics list. Diversification has similarly been mentioned in a number of write-ups on sikasem.org.
In the post about Treasury bill vs. mutual fund, the importance of diversification and how mutual funds offer diversification opportunity was highlighted. The significance of diversification has also been covered in the following posts:
4 DUMB financial decisions I had made in the past
What is the ‘best’ investment product in Ghana?
Wealth tracking: Manage your wealth with Spf wealthTrack
With the availability of abundant information and varying perceptions, following an effective and practical diversification approach can be challenging. Nevertheless, all diversification methods intend to reduce investment risks and volatilities by investing in a variety of assets classes or categories. At least, reducing investment risk, to some extent, can give you some peace of mind
Determining your assets mix
The main concept behind assets mix is that the growth of different assets categories can progress independently in different directions. For example, the growth of stocks is usually based on the prospects of companies. On the other hand, Treasury bills and bonds are mostly affected by prevailing interest rates.
In a way, you hold different kinds of assets whose values neither grow nor fall at the same time. Thus, when stocks perform poorly, one may be cushioned by Treasury bills or bonds.
The list of assets categories can be many. The common ones are stocks, mutual funds (equity, balanced, money market), Treasury bills, fixed deposits, bonds, savings accounts, cash, commodities, real estates (properties) and businesses.
What is a good mix?
Arguably, there is no ideal formula when it comes to assets mix in diversification. How one chooses and mixes his assets ultimately depends on factors such as his financial goal, financial situation, age and level of risk he can cope with.
Your financial goal could be building long-term wealth or an alternate retirement fund. With such a goal, your assets mix would be inclined towards long-term assets such as stocks and equity [mutual] funds. In other words, you would require an asset mix made up of a high percentage of long-term investment products.
On the other hand, if your goal is to create a source of regular income for the immediate to medium term, you may find it useful to have a mix comprising greater percentage of fixed income products.
While focusing on your financial goals, you also consider how much risk you’re prepared to take to achieve those goals. For instance, if you’re the type who easily panics after losing some investments, then you may not be in the right position to allocate greater portion of your assets to risky investment products.
It is also noteworthy to consider mixing assets within the same category. That is, you don’t only diversify across different assets categories but also within the same category.
In doing so, you diversify within stocks category by investing in different stocks on the market. This must also cover different industrial sectors such as banking stocks, manufacturing stocks and insurance stocks.
Considering foreign stocks, beyond just the Ghana Stock Exchange could even be more helpful. This is because different markets don’t normally grow in the same direction. When Ghana Stock Exchange performs poorly, Johannesburg stock market may be performing better.
The easiest way to invest in foreign stocks is to purchase equity funds that invest beyond the GSE. Typical examples of equity funds that invest invest beyond the GSE are Databank Epack fund, HFC F-plan and SEM All-Africa fund.
In addition, you diversify within fixed income securities by purchasing T-bills, bonds and probably fixed deposits. Similarly, you diversify within mutual funds by investing in equity funds, balanced funds and money market funds.
You may even consider other alternative investments such as gold and antiques if you have the means.
Rebalancing your assets mix
As your assets keep growing, the original mix may become distorted due to the different growth rates of the different assets categories. Furthermore, your investment goal may change at any point in time.
Thus, it would be necessary to regularly monitor and rebalance your assets mix. Stay abreast with current market updates and make use of the information to help rebalance your assets. The use of Spf wealthTrack can also guide you to know which assets categories require adjustments.
Avoiding over diversification
As earlier stated, a few seasoned investors have had their criticisms on diversification. For example, Warren Buffett, an American business magnate and investor, made a remark concerning people’s obsession about investment diversification. He argued:
“Wide diversification is only required when investors do not understand what they are doing.”
Deducing from the above statement, Warren Buffett does not entirely consider diversification as a bad practice. Rather, his concern centres on over diversification and the notion that diversification is the ‘Messiah’ of investment growth. Yes, too much of everything can be bad too.
In fact, over diversification can even hold you back from potential earnings. For instance, anyone who might be precisely utilising the GSE Composite Index (used to track all stocks on the exchange) for his diversification approach may not be making more returns as the one who rather focus on a few profitable stocks on the market.
This is because even though the stock market records negative returns in some financial years, a few individual stocks make huge gains in the same financial years.
It may similarly be needless to invest in numerous mutual funds in the name of diversification. Don’t forget that the investment strategies of most collective investment schemes in Ghana follow similar patterns. At least, a look at my previous post on foundational stocks can give you a clue.
Selecting a few good schemes based on past fund performance and reputation of fund managers can be a good way to go. Essentially, get to know your mutual funds so as to have a vivid picture of what they invest in. In that way, you avoid stashing your money in repeated portfolios.
To conclude, diversification of investment can be very useful in reducing one’s exposure to market volatilities and other investment risks. However, it must not be like spreading your tentacles everywhere with no focus.
The main point is to focus on a few and manageable number of assets in different categories while considering your financial goals.