Points to Note for Diversification

“Don’t put all your eggs in one basket.” Everyone should be familiar with the principle of diversification.

However, if the baskets of eggs are all placed around the edges of the same cliff, putting the eggs in different baskets may not be enough to make us feel at ease.

Diversification reduces risks because changes in the macroeconomic environment are expected to have varying impact on different asset classes, industries, and markets. When an economic and financial event occurs, there may be differences in the performance of different asset classes, industries, and markets.

We can diversify investment risks by investing in different asset classes, industries and/or markets.

• Asset class
  Stocks, bonds, cash, and alternative investments, such as real estate and commodities, all have different investment features, and may be affercted by changes in the financial and economic environment.
• Industry
  Economic cycles can have varying impact across industries. For example, some industries, such as real estate, consumer discretionary, and those with higher financing needs may be more sensitive to interest rate hikes; while others such as financial services may benefit.
• Market
  Every economy has its own economic cycle, industrial structure, and economic and social issues. Investors may consider allocating their investments across various countries and regions.

We should avoid concentrating our investments in a particular asset, industry, or market. To effectively diversify investment risks, we should understand the correlation between different investments. When the performance of two investments is inconsistent (low correlation) or opposite (negative correlation), the effect of risk diversification is more pronounced.