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Why diversification reduces your investment risk

by , 10 April 2015

Diversification is an essential aspect of portfolio management. By not putting all your eggs in one basket, you can reduce the risk you take on when investing.

So why does diversification work? And should you bother?

Read on to find out more…

What is diversification is all about?

The idea behind diversification is you spread your stock market risk by investing in a number of different securities. In doing this, you reduce the risk of investing in only one sector or share on the Johannesburg Stock Exchange.

Depending on the type of investor you are, you’ll have investments across different securities. For example, 60% in shares, 15% in property, 15% in bonds, 5% in gold and 5% in cash.

But you need to spread your risk further by ensuring you don’t invest too much in one specific security. And this is the whole premise behind diversification.

Let’s take a look at a simple example to illustrate how diversification works…

How diversification reduces your risk

Tim has all of his cash in stocks in the telecommunications sector. He has half in MTN shares and the other half in Telkom shares.

It’s clear that Tim hasn’t done much to offset risk. All of his cash is in one sector of the stock market.

His friend Mark is a bit different. He has his cash invested in eight different shares, which are across five different sectors. His holdings are in retailers, telecommunications, banks, industrials and gold miners.

By doing this, he has reduced his sector specific risk.

If something happened in the telecommunications sector that hit share prices hard, Tim’s portfolio would feel the effects. On the other hand, only a small portion of Mark’s share would suffer as a consequence.

Mark’s share portfolio would be in a much better position than Tim’s.

And that’s why you have to ensure you diversify your share portfolio.

So there you have it, why diversification reduces your investment risk.

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Why diversification reduces your investment risk
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