Why diversification is key for a smart investor

Divide your portion to seven, or even eight, for you do not know what misfortune may occur on the earth - Ecclesiastes 11:2

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BY DAVID ONJILI

Any investor’s aim is to make the most of returns while in the meantime cushioning themselves against risks, most notably losses, and the peace of mind that your investments are diversified. The reasoning behind diversification is that different industries will respond differently to the same event. Take a strike notice by pilots as an example; such notice will shake stocks that are allied to the aviation industry while those in the mining, banking and other sectors may be spared. It is such eventualities that a sharp investor seeks not to fall a victim of.

While diversification is not a security against losses, it is an elementary component of reaching your financial goals while minimizing risks. Smart investors minimize or avoid risks. To understand diversification, we must identify with the two main types of risks when investing. Namely; systematic risks and unsystematic risks

Systematic risks.

Also known as undiversifiable or market risks, these are risks associated with every company. Their common causes include inflation and exchange rates, political instability, and war. These types of risks are not specific to any particular industry or company and cannot be eliminated or mitigated through diversification. Investors have no other option but to live with them.

Unsystematic risks

They are risks specific to a company, industry, market, economy or country. They can be reduced by diversification and commonly fall under business and financial risks. A shrewd investor thus invests in assets that won’t all be affected by the same market events.

For instance, you have a portfolio with Kenya Airways stocks. If pilots announce that they will be on strike and that flights might be cancelled, the share prices of Kenya Airways stocks will fall and subsequently your portfolio will drop too. However, you can cushion yourself by having shares from the telecommunications sector say Safaricom shares. The strike by the pilots and fall in share prices will not affect those by Safaricom and thus a loss on one side is cushioned by a gain or steady stock elsewhere.

If this is not enough, you can even purchase stocks from building companies, those in the hospitality industries, construction and financial services. With these industries being independent of each other, one stock negatively affected by events in the market will mean that you can cushion yourself with the other stocks.

Asset class

An asset class is simply a group of securities that exhibit similar characteristics, behave similarly in the market place and are subject to the same laws and regulations. The three main asset classes are equities or stocks, fixed income and money market instruments

Money market instruments are debt issues whose maturity are less than a year and preferred by institutions and individuals who prefer to be liquid. Add to the fact that they are also issued at a discount to their face value and thus very attractive.

Bonds are a good example of fixed incomes, they are periodic income received at fixed rates issued by governments or major corporations that are seeking funds to finance their activities. Treasury bonds and Treasury bills are good examples. If you purchase one worth Sh1, 000, 000 issued at a fixed rate of 9% then you expect an interest of 9% of Sh1, 000, 000, which is Sh90, 000 every year. Isn’t that a fixed and steady income?

However diversified your portfolio is, you can never eliminate risks completely, the better approach would be to reduce risks associated with individual stocks by diversifying across asset classes. True mastery of investment is achieved by striking a balance between good returns and peace of mind. Knowing that one area may not affect another area in your portfolio is key to this.

Since different people have varied reasons why they invest, individually know your final goals and tolerance to risks. This can be best achieved by contacting a licensed financial advisor. They will charge you a fee but the information will be invaluable far better than investing without any knowledge, which is akin to gambling.