We often hear people saying that it does not make for prudent financial practice to keep all our eggs in one basket and that we need to diversify our investments. However, what do we mean when we say diversification makes for good investment practice?
Simply put, diversifying is the concept of spreading your investments across a range of types of investments – from stocks to bonds, from bonds to mutual funds. In short, what you are trying to do is hedge against one of your investments going down, while another goes up. Conversely, if you put all your investments in one basket, say stocks, then you have not hedged against what may happen in the event that your stock investments depreciate in value and you’ll take a hit!
The following are considered good strategies for diversifying your investments:
- Stocks – represent shares of ownership in publicly listed companies. If you want to diversify your investments, pick lots of smaller stocks to invest in rather than one large stock investment;
- Bonds – can be issued by private/public limited companies or by the government. In short, you agree to lend money to the company/government in return for which the company/government agrees to issue you with a promissory note to repay in the future with a fixed interest. Sometimes you’ll come across a convertible bond, which will entitle you to convert your outstanding right into shares of the company in certain circumstances. In the meantime, if you want to sell the bond before the maturity date of the loan, you can do so at a discount of the “face-value” of the bond, i.e. the amount the holder of the bond will be paid on maturity date. Bonds are a favorite among diversified investments as they offer both a guaranteed fixed return and a fairly easily option to sell in the secondhand bond market.
- Mutual Funds – mutual funds are where a group of investors pool their money and the pooled money is used to make investments in a range of specified investment products. Mutual funds are a very popular means of diversifying investments as not only do you invest in a large number of financial products, but you also have the comfort of knowing that these investments are being made on behalf of a number of people within your mutual fund and not solely at your own risk!