Last time I mentioned the need to diversify when you invest money. Many people either wonder "why diversify?" and they don't do it, or they don't even think about it. Why do you need to diversify? To eliminate unnecessary risk.
The old saying "don't put all your eggs in one basket," is a very wise and true one. You could put all your eggs in one basket if you think it's strong, but if you're wrong and it breaks, then you'll lose everything. Put them in two baskets and you'll be less likely to lose them all? Yes, you're more likely to lose some eggs, but it's better than losing them all, right?
Diversifying your investments work in the same way. There are two types of risk associated with investments.
Unsystematic (or diversifiable) risk is the risk a particular company/share has of losing (or gaining) value. An example of unsystematic risk in coca-cola shares is the CEO could die, or a survey coming out claiming drinking coke shortens your lifespan by 20 years.
These events will cause coca-cola shares to lose value, but it wont effect the value of any other shares (except maybe pepsi ;)
This kind of risk can be diversified away by investing in multiple companies/shares. The less related the companies, the better the diversification. An example would be investing in coca-cola and microsoft shares.
Systematic (or undiversifiable) risk is the risk you face for investing in the share market itself. This risk causes all shares to lose (or gain value). An example of systematic risk is the current credit crisis. This is making people sell their shares and since there's no one buying, the shares lose value.
You cannot diversify this risk away since all shares are affected by these events.
I will add a chart later to show how diversification can reduce your total risk to a degree. But I hope I've shed some light on why it's important to diversify your investments. While it's great that people want to invest and even get together in groups to decide what to invest in every month or so, it's saddening that these people are taking more risks than they need to be..
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5 comments:
Great read. Very well written and easily understood by non-technical readers like me.
What are your thoughts on investing in the property market in the next couple of months and then giving that property out for rent?
-Gurpreet
I'm a bit biased about investing in the property market because I don't know that much about it. So I'm not the best person to ask, but I'll give my answer anyway...
which is no. The main reason is you will not be very diversified and alot of your money will be tied up in the property market.
Also, interest rates are high and people aren't willing to accept a lower price for their house yet (even though they should).
nice article. i think investing should be made by those who have a good deal of knowledge about the area where they are putting the money into. do you agree?
eg. investing in shares at a food based company .
so to diversify, the investor would also need to learn about the other areas.
adam
yeah, I was thinking of talking about that soon. You definitely should have knowledge in the area you are going to put your money, as well as being able to read the financial statements and what not.
Even if you are knowledgable in one area and can invest successfully, you never know what can happen. An example is you may know what will happen to oil prices relating to government regulation, supply and demand etc, but if some random person sued a company for a multi-million dollar lawsuit for anti-competitive behaviour, and the judge allowed the case to be heard because they had some valid points, you would lose alot of money if you had invested in the oil industry with the expectation that it would rise..
yea thats probably why some people take up financial advisors, thinking that they would be up to date and knowledgable with a wide range of investing areas.
the rouge trader at the french bank makes me laugh. i wonder if he diversified, and where he put all that money.
adam
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