Diversification is spreading investments across different assets, sectors, and geographies to reduce risk. The principle: don't put all eggs in one basket. Concentration in single company, sector, or country means one failure destroys entire portfolio. Diversification reduces this specific risk while maintaining growth potential. Most important free lunch in investing - lowers volatility without sacrificing long-term returns.
Diversification is the practice of spreading investments across different assets, companies, sectors, and regions to reduce risk. When one investment performs poorly, others may perform well, smoothing overall returns.
"Don't put all your eggs in one basket"
1. Asset class diversification:
2. Individual holding diversification:
3. Sector diversification:
4. Geographic diversification:
Diversification reduces specific risk (risk unique to individual investments) but not systematic risk (market-wide risk that affects everything).
Scenario A - Concentrated (both tech stocks):
Scenario B - Diversified (tech + utility):
Example: All savings in employer stock
Real example: Enron employees (2001):
Any single company can fail regardless of how strong it seems. Diversification protects against this.
Property (Real Estate):
Shares (Equities):
Cash/Bonds:
Different performance in different conditions:
| Economic Condition | Property | Shares | Cash/Bonds |
|---|---|---|---|
| Boom (growth) | Strong | Very Strong | Weak |
| Recession | Weak | Weak | Strong (safety) |
| High inflation | Good (prices rise) | Mixed | Poor (eroded) |
| Low inflation | Moderate | Strong | Good |
No single asset performs well in all conditions. Diversification ensures something working in every environment.
Concentrated (all property):
Diversified (40/40/20):
Property crashes -30%:
Diversification reduced loss from -30% to -8% by spreading across uncorrelated assets.
Investing heavily in one industry sector (banking, technology, energy). When that sector struggles, entire portfolio suffers.
Common NZ investor holdings:
Feels diversified (4 different banks) but all banking sector - highly correlated. When banking sector hit, all fall together.
Banking sector:
Technology sector:
Energy sector:
Spread across sectors:
No single sector dominates - protects against sector-specific crashes.
NZ-only portfolio vulnerable to:
Access to growth everywhere:
Currency diversification:
Example allocation:
Background (2007):
Banking sector devastated:
Robert's portfolio impact:
If Robert had been diversified:
Diversified portfolio lost 21% vs Robert's 48% - half the damage from same crisis.
Final insight: Diversification spreads investments to reduce concentration risk - don't put all eggs in one basket. Single asset exposure dangerous: company failure, sector decline, country crisis wipes out wealth. Property vs shares vs cash have different characteristics, move differently, owning mix reduces volatility. Property stable but illiquid, shares volatile but liquid, cash safe but inflation erodes - balanced portfolio performs consistently. Sector concentration: NZ investor heavy in banks vulnerable when banking crisis hits all simultaneously (Robert lost 48% vs diversified 21%). Geographic concentration: NZ-only portfolio vulnerable to NZ-specific events, missing global growth opportunities. NZ represents <1% global market. Robert scenario: $400k all in NZ bank shares (ANZ, Westpac, NAB, CBA), felt diversified but all banking sector, 2008 GFC hit banks hard, lost 48% while diversified lost 21%, learned 4 banks ≠ diversification. Checklist: own multiple assets, spread across sectors (no sector >30%), include international (NZ <50%), avoid employer stock concentration, rebalance annually. Diversification is "only free lunch in investing" - reduces risk without sacrificing long-term returns.
Quiz on Diversification
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