Harry Markowitz who founded Modern Portfolio Theory called Diversification “the only free lunch in investing”. What does this mean though?
For me, a good way to explain this is diversification is like having many eggs in lots of baskets. This can protect the investor if one of the “eggs” breaks– it is a way to spread the risk of investing.
When investing in companies (via shares or bonds) there is a risk of a loss of capital if the value falls and the share/bond is then sold. Holding a share in one company would therefore represent holding one egg rather than holding shares in many companies (many eggs). The former will likely haves a higher chance of a capital loss. By diversifying, you spread the risk, for example, you could own shares in an umbrella company and a sunbed company or shares in the UK and Overseas.
My experience is that many investors do not hold shares/bonds directly but rather in a fund as this can allow for less paperwork and more simplicity. However, a portfolio should not automatically be considered diversified just because it holds a number of funds as these funds may be invested in the same shares/bonds. It can pay to check the underlying holdings.
There are many different views on the best way to invest and without knowledge of the future; we cannot know which is best. However, one common approach is to invest in more than one share/bond to diversify but to hold a concentrated portfolio of the potential future “winners”. An alternative approach is to invest in all shares/bonds in a specific market (akin to buying the haystack rather than looking for the needle).
As discussed in previous articles our philosophy at Blackdown Financial sits somewhere between these two options but what all three are designed to do however is to diversify and spread the risk.
Clearly, what the money is for will play a part. Money for our/our family’s financial future may be invested in a diversified manner whereas money we want to “play” with might be held in single company shares/bonds. There is no “one size fits all” approach.