Harry Markowitz, the pioneer of Modern Portfolio Theory, famously described diversification as “the only free lunch in investing.” This metaphor signifies the unique benefit of diversification: it allows investors to reduce risk without sacrificing potential returns.
To illustrate, think of diversification as not putting all your eggs in one basket. By spreading your investments across different assets, you protect yourself from the negative impact of a single investment failing. If you invest all your money in one company and it underperforms, you face a significant loss. However, if you diversify your investments across multiple companies, industries, or asset classes, the poor performance of one investment can be offset by the better performance of others.
When investing in companies through shares or bonds, the risk of capital loss exists if the value of these assets falls. Holding shares in just one company is akin to having all your eggs in one basket, increasing the likelihood of significant loss. Diversification, on the other hand, spreads this risk. For example, owning shares in both an umbrella company and a sunbed company, or in companies from different regions like the UK and overseas, helps mitigate the risk associated with any single investment.
Many investors prefer to invest in shares or bonds through funds for simplicity and reduced paperwork. However, merely holding multiple funds does not guarantee diversification. It’s crucial to examine the underlying assets of these funds to ensure they are not overly concentrated in the same shares or bonds. A diversified portfolio should contain a variety of assets that do not move in the same direction under similar conditions.
There are different approaches to diversification. One common method is to invest in a range of shares or bonds to spread the risk. Another strategy involves concentrating on potential future “winners,” while a third approach is to invest in all shares or bonds within a specific market, akin to buying the haystack instead of searching for the needle. At Blackdown Financial, our philosophy sits somewhere between these strategies, but all aim to diversify and spread risk.
Diversification remains a cornerstone of sound investment strategy. By spreading investments across a wide array of assets, investors can achieve a balance that reduces risk and enhances the potential for stable returns, truly making it the only free lunch in investing.
Neil Rossiter is a Chartered and Certified Financial Planner and can be contacted on 01823 321616 or neil@blackdownfinancial.co.uk.
N.B. The value of investments can go down as well as up and you may not get back the full amount you invested. The past is not a guide to future performance and past performance may not necessarily be repeated. The Financial Conduct Authority (FCA)
