Divesification 101

Before even making money, most investors are more concerned about losing it. Loss aversion in behavioral finance explains the individual bias that the negative feeling from an investment loss is 2.5 times more potent than the joy of an equivalent gain. For instance, a N10 loss is 2.5 times more painful than the pleasure of a N10 gain.

Unfortunately, we are also insatiable gain seekers. Despite the weight of losses, we still desperately need to increase our wealth, and this need can be most intense when we are experiencing losses.

Fortunately, humans are blessed with high intelligence, which helps us solve or circumvent problems that could threaten our innate desire for growth. Enter diversification, a popular tool in the investment world used to protect against the poor performance of a single investment. Due to the fear of loss mentioned earlier, diversification was created to help us achieve our ambitions and increase our wealth while mitigating the potential loss associated with these ambitions.

It's intuitive that if you don't want to lose money investing, you should invest in what we know as safe assets. Although no investment is completely guaranteed against loss, there are investments with a substantial probability of safety. The caveat is that they offer low returns.

Remember the human insatiable gain-seeking attribute we just discussed? It drives us to seek higher returns from our investments, but increased returns often come with increased risks.

Diversification aims to reduce the risk of substantial losses by investing in a variety of assets that are not closely correlated. This means that even if one investment performs poorly, others may still do well. Just like the saying "don't put all your eggs in one basket," should something happen to a basket, you don't lose all your eggs. While diversification is a valuable tool for managing investment risk, an overemphasis on loss prevention can overshadow its other benefits and may even lead to suboptimal outcomes.

Understanding what diversification is and is not is the first step to harnessing its benefits.

What diversification is not:

• Investing in multiple assets without considering their respective risk and relationships.
• Investing in equal amounts in multiple assets.

 

What diversification is:

Risk allocation: When faced with a choice of multiple assets, diversification helps you choose the investments that are worth investing in and how much of your entire investment should be held in each asset to produce the most return.

Return optimization: Increasing return for every investment risk taken.

Diversifying investment properly

In practice, diversification requires more technical input than simply spreading investments across multiple assets. You'll need an understanding of various asset classes, the factors that affect their performance, and some quantitative skills. While these might seem intimidating, one rule of thumb for investing is not to invest in assets that share similar characteristics or are too closely alike. One common example is investing in multiple assets in the same industry, such as investing in multiple automobile or banking stocks. Because these assets share similar characteristics and are affected similarly by their driving factors, the tendency for these assets to have similar performance is very high and offsets the benefits of diversification.

Diversification is one way to prevent investment losses and doing it properly can be pivotal in achieving investment outcomes. We advise that individuals consult a skilled professional to assist in structuring their investment to be diversified appropriately.