Private investors are often told that one of the most important tenets of investing is diversification. It apparently helps to reduce risk so that if there is an unfortunate event in one part of the world, one economy or one sector, then the investor’s portfolio will not be completely wiped out.
However, the reality is that the world is more interconnected than ever. Globalization means that what happens in one part of the world affects the rest of the globe. And as the credit crunch showed, even one industry can cause chaos for all industries across the world.
A changing global economy
Clearly, the idea of globalization is nothing new. For decades, the policy of the developed world has been to trade wherever possible without tariffs and encourage development in the emerging world. This has aided countries such as China in their development, but has also helped the developed world since the price of manufactured goods has remained relatively low.
This is just one example of the increasingly close ties which different regions and countries have with one another. As a result, if one of them endures a challenging period then it is likely to affect the others.
Similarly, the credit crunch showed that what started in the real estate industry in the US could quickly spread throughout the global banking system. This caused a number of major, global banks to go under and even meant that countries across the globe such as Greece ended up with sky-high debts and a declining economy.
During the credit crunch, it was exceptionally difficult to find assets which offered security. Gold was falling, bonds were volatile and cash returns were generally behind inflation. Therefore, it could be argued that diversification is not even possible during the worst economic crises.
Specific risks
While diversification is unlikely to protect any portfolio against a global recession or banking crisis, the reality is that it does still offer huge value for private investors. For example, on a company level it reduces company specific risk. This means that if a holding within a portfolio experiences a profit warning or some other adverse event, the total loss will be limited for a diversified investor. Similarly, if an industry experiences a challenging period, for example the airline industry in the wake of reduced demand, then a diversified investor’s portfolio could offset this with stronger performance elsewhere.
Beyond shares
Furthermore, diversification between asset classes also holds significant value for private investors. During the credit crunch, cash may have returned less than the rate of inflation as a general rule, but versus double-digit falls in share prices it performed relatively well. Similarly, holding bonds also has value while interest rates are falling and property could provide a degree of stability when share prices are coming under pressure.
While diversification will never do away with risk completely, it does reduce risk significantly. Therefore, it is still necessary for risk averse investors.
