IN the most recent articles my colleagues and I have broken down investment in securities to its simplest form, highlighting fundamental investment principles that all current and potential investors should appreciate. This article will seek to continue that thrust to open your “investment eyes”.

Whether or not this is a refresher for some, this is very important as we emphasise that all Jamaicans need an investment portfolio. We will be pulling apart the practice of diversification and its crucial role in investment. In this article, we’ll provide an overview of diversification and give you some insight into how you can make it work to your advantage through investment vehicles such as mutual funds (for example, CI Mutual Funds) and ultimately make your investment life easier.

Diversification by definition is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments (securities) will on average yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralise the negative performance of others.

Let’s take a closer look at the concept. Do you remember the term “Don’t put all of your eggs in one basket”? While that sentiment certainly captures the essence of the issue, it provides little guidance on the practical implications of the role diversification plays in an investor’s portfolio and offers no insight into how a diversified portfolio is actually created. Consider, for example, an investment that consists of only stock/equity issued by a single company. If that company’s stock suffers a serious downturn, your portfolio will sustain the full brunt of the decline. By splitting your investment between stocks from two different companies or even industries, you can reduce the potential risk to your portfolio.

Another way to reduce the risk in your portfolio is to include securities like bonds, equities, mutual funds, exchange traded funds (ETF) and cash. Because cash is generally used as a short-term reserve, most investors develop an asset allocation strategy for their portfolios based primarily on the use of stocks and bonds. It is never a bad idea to keep a portion of your invested assets in cash or short-term money-market securities.

Regardless of whether you are aggressive or conservative, the use of asset allocation to reduce risk through the selection of a balance of securities for your portfolio is a more detailed description of how a diversified portfolio is created, rather than the simplistic “eggs in one basket”. Having a good financial advisor to assist in this is of utmost importance. Please note that no financial advisor can protect you from fluctuations in the market nor can they predict when that will happen, therefore diversification is extremely important in an investment portfolio.

Proper asset allocation (breakdown between stocks and bonds, and so on) also affords a higher level of protection. Our previous article spoke in depth about mutual funds: an investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and similar assets. These money managers invest the fund’s capital and attempt to produce capital gains and income for the investors.

Diversification is one of the many advantages of investing in mutual funds. When it comes to diversification, mutual funds can help an investor in two ways. First, the beauty of mutual funds is that you can invest a few thousand dollars in one fund and obtain instant access to a diversified portfolio. Otherwise, in order to diversify your portfolio, you might have to buy individual securities, which exposes you to more cost and risk. A mutual fund also allows for further diversification between various styles, sectors, industries, and countries etc. You can either buy a mutual fund that is broadly diversified, or you can buy a portfolio of mutual funds across various sectors, thus creating your own diversification.

In summary, diversification in your portfolio will provide stability and minimise risk exposure. Adding a mutual fund to your investment portfolio allows for diversification between many different securities, various sectors and styles, and so on. This diversification allows investors to reduce the risk of one particular stock or sector, but also allows for more potential reward by offering a broader exposure to various stocks and sectors.

It is to be noted that you don’t invest in mutual funds but through mutual funds. Mutual funds provide exposure to almost all asset classes like equity, debt, gold and real estate. They are a well-managed and diversified investment vehicle. One need not look at anything else, as one can design his entire investment portfolio using mutual funds.

Andre Edwards is a financial advisor at Stocks & Securities Ltd. contact: aedwards@sslinvest.com