Financial Freedom SG

The people who end up with mega fortunes have their wealth concentrated around the company that they built or have huge amounts of shares given to them.

Bill Gates, Warren Buffett, John D. Rockefeller, Henry Ford etc are some examples from present and past.

The flip side is that this concentration of wealth can also lose you everything. Just ask the Enron employees who used their savings to buy into their company or the Bear Stearns people who did the same. Ditto for Lehman Brothers. When you lose your job AND your savings it would seem like the end of the world.

The majority of us aren’t Bill Gates or Warren Buffett, so for the ordinary mortals, it is important to learn what is diversification.

According to the Wikipedia, it is a risk management technique related to hedging, that mixes a wide variety of investments within a portfolio. The reason for diversification is so that any drop in one investment will have less impact on your portfolio as this minimizes the risk from any one investment.

The 4 keys to successful diversification are:

1. Non-correlation- that is the investments are not directly correlated with one another. In simple terms, it means that if you have 5 bank stocks it is not as diversified and more risky than a portfolio with 1 bank, 1 transport, 1 medical, 1 food and 1 manufacturing company, all else being equal.
   
2. Use of Multiple Investment Types- a well diversified portfolio should not just consist of just stocks and shares. It should be in the form of unit trust, bonds, money market funds etc. Recently, there are even people who advocate that one should put in commodities, currencies, real estate etc as well into the mix.
   
3. Variation Across Geographical Region- as I was writing this, Greece, Portugal, Spain, Italy (some very cheeky people gave them an acronym as PIGS) are in trouble, which illustrates the need to diversify not just out of your country but also out of your region too. If you are an investor in Greece and fully invested in your own country’s stocks, you should be looking to diversification.
   
4. Time aspect- while this is not really covered under diversification, I believe that this is another aspect of spreading risk. If you have $10,000 right now, do you plonk it all in at one time? Or would you be better off spreading the purchase to 2 or 3 separate ones. Some may argue that you save brokerage and transaction cost by buying at one go. Or that the market may go up and up while you buy later and get less stock. I am a believer of dollar cost averaging which practices this aspect of time diversification by putting a part of my salary into index funds straight away.

With diversification properly done, you spread your risk and decrease it as the fluctuation of your portfolio decreases on the whole and you actually get a higher return. It is about the only time that it is possible to have higher or nearly the same returns with lower risk.

My wife and I have nearly half of our investment out of Singapore, into either the region or the wider world outside. Do you use the portfolio approach to investment?