The importance of diversification to achieve retirement goals

Mitigating the impact of any single underperforming investment

Diversification is a risk mitigation technique that aims to reduce losses by allocating investments among a variety of financial instruments. It is a critical aspect of effective portfolio management. A key strategy to achieve this goal involves carefully selecting assets with desirable long-term returns while ensuring a relatively low correlation among them. Warren Buffett is quoted as saying, “Wide diversification is only required when investors do not understand what they are doing.”

Risk diversification plays a critical role when investing in shares. There are different types of risks to evaluate to achieve diversification, as discussed below.

Portfolio risk management

Investing in only one sector or industry increases the exposure to sector-specific risks. Diversification helps to manage the overall risk of the portfolio by investing in a variety of companies or sectors. This way, even if one or a few investments do not perform well, others in the portfolio may balance out the losses. For example, a portfolio only investing in technology startups could suffer significant losses in a technology downturn. By diversifying across multiple sectors, an investor can mitigate the impact of sector-specific downturns.

Geographical risks

Diversification can also be achieved by investing in companies located in different countries or regions. This strategy can mitigate the risk associated with economic or political instability in a specific geographical area.

Reduction of idiosyncratic risk

By diversifying across many investments, an investor can reduce the idiosyncratic risk, or the risk associated with individual companies. For instance, a company might perform poorly due to bad management decisions, unexpected competition, or other company-specific issues. By investing in a broad array of companies, investors can lessen the impact of any one company’s problems on their overall portfolio.

Varying stages of business lifecycles

Companies at different stages of their business lifecycle (e.g. startup, growth, mature) have different risk-return profiles. Diversifying across companies at different stages of their business lifecycles can provide a balance of risk and potential return. An example of this is dividend paying stocks (value stocks) versus non-dividend paying stocks (sometimes known as growth stocks).

Enhancing long-term returns through portfolio stability created by diversification

Portfolio stability is achieved when a portfolio is diversified by investments being spread across different asset classes, sectors and geographies so that poor performance of one investment is offset by the gains of another. Investors stand to benefit from constructing portfolios where the assets are not perfectly correlated, as this leads to smoother portfolio performance and less volatility in returns. This is an effective means of enhancing long-term returns.

Diversification considerations at different periods of the retirement savings timeline

Understanding investment strategies for different life stages can help you plan better for your goals. It is important to take a closer look at the process of investing in each stage of life.

Our lives can largely be divided into four major stages, and each stage requires a different approach to investing.

1.     Young adulthood (20s to early 30s):

At this stage, you have fewer financial responsibilities and a longer time horizon to grow your money. Your focus can preferably be on saving aggressively and investing in higher-risk options for higher returns. It is at this stage that the young investor should be invested in shares or exchange traded funds to benefit from the single asset class that has beaten inflation over the long term.

2.     Mid-life (30s to 40s):

During this stage, your responsibilities increase. You may have to support a family, buy a home or plan for your child’s future. Balancing risk and safety becomes important. As they enter this stage of life, investors should be looking to deploy savings to service debt, but they should still invest in shares to benefit from long-term growth.

3.     Pre-retirement (50s to early 60s):

As retirement approaches, it’s time to focus on protecting your wealth. Investments should be more stable to avoid losses. During this phase, an investor would do well to consolidate wealth by reducing their share exposure and increasing exposure to unit trusts and fixed income instruments.

4.     Retirement (60s and beyond):

The focus here shifts to generating regular income from your investments to support your lifestyle. Stability and liquidity become crucial.

Conclusion

Diversification limits the negative effects of market fluctuations, enabling investors to achieve more stable returns. It also helps optimise investment returns by making it possible to take advantage of opportunities in different sectors and regions. Sector diversification lowers your portfolio’s risk because different asset classes do well at different times. Having a variety of investments with different risks will balance out the overall risks in a portfolio. Investors who want to ensure their portfolios are set up for the long term to deliver on their goals should consider diversifying across asset classes, sectors and geographies.