THE concept of portfolio diversification and the importance of ‘not putting all your eggs in one basket’ has become even more critical in our current challenging economic environment. Investors need to be aware of various opportunities in the market and how to make the best use of them given your personal financial status.

But, first of all, what is portfolio diversification? Diversification involves investing across various asset classes in order to preserve capital whilst maintaining optimal returns.

Why is it important to diversify your portfolio?

Consider this: the sale of bun and cheese peaks in the Easter season, while in the Christmas season, the sale of smoked hams and poultry/chicken climax based on social and traditional practices. Both products being seasonal have their greatest sales at different times of the year.

This would pose an issue with a portfolio which is weighted with Easter products as it would only perform well in the Easter season, and one weighted with Christmas products only would perform well in the Christmas season.

To eliminate this, one would opt for a portfolio with a combination of both which would eliminate the seasonality of earnings, thus providing a more optimal source of income throughout the year. The idea is to have a stake in both products so that when the sales of one slump, the other is likely to perform well and vice-versa.

The importance of this concept is easily identifiable when observing the financial markets, locally and globally. Empirical evidence has shown, time and time again, that when Jamaica’s exchange rate is stable and money market yields are low, investors move towards the stock market. The reverse is also true, when the stock market falls, investors favour safer investments such as fixed income securities or the conversion to stronger currencies.

One suggestion is to invest a fraction of your wealth in the equities market as part of a long-term strategy, while maintaining some fixed income investments and holdings in a more robust currency. Unit trust products and mutual funds are an alternative to the equities market and they offer the benefit of being professionally and actively managed. An optimal combination of assets should result in the preservation of capital and provide consistent returns.

While it’s important to diversify, it is equally important to not over-diversify. Overdiversification occurs when you spread your funds across too many asset classes and it results in the minimisation of your returns. For example, investing in every stock on the Jamaica Stock Exchange (JSE) would be counterproductive, but a more concentrated approach of selecting a few quality stocks would be more appropriate.

Diversification is one of the most important pillars in any investment strategy and it generally leads to the preservation of capital and the generation of consistent returns. This is a clear confirmation of the old adage ‘do not put all your eggs in one basket’. It is imprudent to invest all your wealth in one asset class, as the potential for losses on your initial investment is greater should negative conditions prevail.

Each individual’s level of diversification will be dependent on their age, objectives and risk tolerance. For investors who are uncertain, it is prudent to contact an investment advisor to guide you through the process. You may contact an investment advisor at SDBG in order to obtain more information on structuring a balanced portfolio that suits your needs while maximising the returns on your investment.

Photo: Portfolios