The well-known proverb “don’t put all your eggs in one basket” is a popular message that is applied to many aspects of life. But have you ever thought about this concept in the context of your investments? Take a hypothetical case: Imagine investing all of your savings in shares of a single company. This company ticks all of your boxes: It is a large company with well-established market segments; good quality products; and a strong management team. But something goes wrong. The share price plummets along with your hard earned savings. This can happen as was the case for Telstra after its float in 1997. To this date the share price of Telstra has never recovered from the highs of the months following its float as can be seen in the chart below.
Let’s take the opposite extreme. Say you invested all of your savings into a savings account with a bank and earnt interest on your savings. With this stable, reliable investment the likelihood of you losing your money is very low. However, the interest rate at the time of writing this post is only 2.85% per annum. Over the last ten years, an investment in the top 500 companies on the ASX has returned over 9% per annum. By investing all your savings in a secure savings account you have forgone the ability to earn a higher rate of return on your savings. This could amount to difference in the order of $millions over a typical career.
Finally, what if you invested all of your savings in a company that experienced great, consistent long- term growth. Take the Commonwealth Bank for example. If you had of invested $10,000 in the Commonwealth Bank during its float your investment would be worth over $120,000 today. But when making that investment back in 1991 how were you to know how successful the Commonwealth Bank would be? Even with careful and thorough research there is no certainty in knowing that the returns on any investment will be high. An investor could have just as easily invested in the National Australia Bank and not have done as well.
So how do investors navigate these situations? The answer comes back to our eggs and baskets. In order to reduce an investor’s risk without compromising high returns, an investor should diversify their portfolio. This means they should spread their savings over a large range of reliable and proven investment classes. An example could be a portfolio that consists of Australian shares, international shares, bonds, cash accounts, and property. With diversification you expose yourself to the returns of each asset class. Since different asset classes have booms and busts at different times, the overall variation in your portfolio will be reduced. Diversification reduces the risk of losing money as your savings are not exposed to just one risky investment. In a diversified portfolio, even if one investment you own depreciates, chances are that the rest of your portfolio has not and thus you have not lost money on all of your savings. On the other hand, some of your investments will be invested in shares and property and thus will be exposed to higher rates of return.
Diversification should also be applied within a single asset class. For example, your share portfolio should consist of investments in more than one company. In fact, personal investors should at least consider investing in ten companies. Furthermore, these companies should be great but different. They should operate in different industries and have different business models. This way if one sector of the economy has a rough patch, the rest of your portfolio will not be exposed to this economic downturn.
For an agricultural family in 1700, it was important that eggs were not carried in one basket to prevent catastrophic destruction of food and income for the family. Personal finances nowadays exist in a very different form. However, the concept of risk minimisation is no different. Diversification has been and always will be an important part of successful financial management.