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It is not known if the American actor was particularly eager or if he was just joking with these words. Anyway, he touched on an important principle that all investors should respect: the principle of “not putting all your eggs in one basket”. When investing, this means not investing all your money in a single asset, but allocating it to a variety of assets. In short: diversifying its investments.
Why diversify?
A day before we wrote this post, the German construction company Bilfinger published a “profit warning” informing the public that its financial results would be significantly lower than it had anticipated. In the space of a few hours, the share price of Bilfinger lost more than 18% of its value.
Imagine that you had previously invested all your money in Bilfinger shares – you would have lost more than 18% of your wealth in a few hours – a nightmare!
This example perfectly illustrates what can happen if we focus our investments on a single asset. It does not take a scientist to conclude that it is better allocate our investments to several different assets.
But beware ! The diversification of our investments alone will not ensure us a profit and does not guarantee that we will not suffer any losses. But diversifying our investments allows us to spread the risks associated with our various investments so that the overall risk for our investment does not exceed the level that we deem acceptable.
It is also necessary that diversification is well done. Indeed, it is not enough simply to buy shares of several different companies, for example, to create an efficiently diversified stock portfolio.
And don’t forget to buy different types of eggs
Imagine that besides Bilfinger, we invested exclusively in other construction companies. We saw in the chapter on share prices that at a Stock Exchange, you don’t trade securities, you trade opinions – particularly opinions on the future development of a company and the securities representing this company. It is therefore very likely that investors will come to the conclusion that if Bilfinger has problems, other construction companies probably have or will have problems as well. In this case, the owners of shares of other construction companies will try to sell their shares too, which will cause the prices of all shares of the construction sector to fall. In that case, our “diversification” has been of no avail.
This example shows how important it is to distribute our equity investments not only into different stocks, but also into several different sectors such as finance, chemicals, steel, biotechnology or trade… We can even go further and allocate our investments to businesses of different sizes, in several countries, in various geographical regions, different currencies, with different investment durations (short term, long term …), or we invest according to distinct strategies (with the aim of either the conservation of capital invested or its aggressive growth).
And of course, it is important not to focus our investments on a single asset – in our example: stocks – but to also consider bonds, precious metals, real estate, bank deposits … knowing that each asset has its own specific advantages and disadvantages.
The ideal is to choose assets whose values do not evolve in the same direction or, which even better, whose values tend to move in opposite directions.
If we invested in shares of an airline, for example, a sharp rise in oil prices will drive up the company’s operating costs (the fuel becoming more expensive). The result will be a drop in the company’s profits – and of the value of the company and its stocks. However, if we simultaneously have some shares of oil producers in our portfolio, there are chances that the oil price increases will push up the turnover and profits generated by these producers – and their share prices. The decline in the value of our airline shares could then more or less be compensated by the rising share prices of oil producers.
The art of diversification is to create a balanced portfolio of assets.
However, diversifying investments can be a costly exercise. Investing € 50,000 in ten different stocks for example will generate significantly higher transaction and brokerage costs than investing the same amount in one single security.
The use of investment funds is one way to achieve a good diversification at reasonable cost.
