Diversification

'Diversification' is another word for 'spreading your risk' or 'not putting all your eggs in one basket'.


How does it work?

If you decide to invest in shares (equities) you may like the oil industry, chose, e.g., BP and put all your money into BP. That's sort of logical.

But businesses are risky affairs and you have put yourself at the mercy of all the accidents that might befall BP. You can still maintain your conviction about oil by splitting your investment between BP and, e.g., Shell. So you've halved your exposure to BP's accidents and taken on some exposure to Shell's accidents: you've 'spread your risk', or 'diversified'.

Except that you haven't done it very well. Both BP and Shell depend on the oil price. You've diversified the risk of, e.g., 'management mistakes' or 'plant accidents' but you've not diversified exposure to a fall in the oil price. You would do better to make your second investment in, say, GlaxoSmithKline.

But why limit yourself to two companies? Perhaps you should reduce your investment in BP and GSK and introduce another industry - insurance, say.

The lesson is.....

You need to build a collection of investments as different from each other as possible, to spread your risk. To do otherwise is to pretend that you have more knowledge than the market - in the BP/Shell example to believe that your assessment of the future of the oil price is better than the market's. And it isn't.

There's much more to be said if you want to get clever. Luckily, you can safely leave this to Advanced Investing.

The collection of diverse investments you end up with is called your 'investment portfolio'. The extent to which two values tend to move together - the stock prices of Shell and BP for example - is called 'correlation'. If they follow each other closely they are said to be 'highly correlated'. If they tend to move in the same direction they are said to be 'positively correlated'. If they tend to move in opposite directions they are said to be 'negatively correlated'.

 

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