Yes, just like the word implies, diversification is a method of spreading investment funds across various categories in order to minimize risk and maximize returns. The rule of diversification states that you spread your proverbial eggs in different baskets such that whatever happens in one doesn’t affect the others.
For instance you have N20, 000 to invest in shares. Diversification means spreading the fund in shares of different companies that are not related (say, a bank, a beverage manufacturer and an engineering company) instead of investing in just one company. That way, if any of these companies loses value, you can still get gains from others.
Why Should You Diversify?
Simply put, nobody knows tomorrow. Diversification reduces the risk of you losing most or all of that money to market fluctuations in one investment class.
Diversification can be done across economies to eliminate currency risks. Diversification can also be done across asset classes that have low risk such as bonds and high risk investments like cryptocurrencies. Diversifying according to maturity periods like having a 30-year bond and one-year commercial paper reduces liquidity risks.
How to Build a Diversified Portfolio in Nigeria (or any economy)
A portfolio is like a suitcase of investments and here are tips on how to make sure your suitcase is well diversified:
- Recognize your investment goal: Investing your money can be for Growth, Income, or Capital Preservation. Knowing your investment goal helps to know your risk tolerance and the type of investments to diversify into. So if your goal is regular income, fixed income investments are generally best but you can diversify into sovereign bonds, corporate bonds, treasury bills, etc.
- Invest in Index Funds: An index is a group of companies or investment options. Index funds are investments pegged to the value of particular indices. So instead of searching for individual companies to invest in a particular sector, you can buy index funds of that sector (usually the same risk applies to companies in the same sector. Not every company in a sector will perform equally, index funds diversify the risks by balancing out the performance of every company in the index. Index Funds can either be Exchange Traded Funds (ETFs) which operate like stocks and are passively managed, or Mutual Funds which are not traded on exchanges and are actively managed.
- Tune out the Noise: In diversifying, do not invest all your money in only asset classes that are dominating the news. Many people have become multi-millionaires by investing in cryptocurrencies as the media reports. However, cryptocurrencies are very volatile and arguably more prone to changes in investor sentiments than other asset classes.
As much as possible, seek financial advice or do your own research because even the most rational investors get side-tracked.