Why diversification is important
Balanced portfolios can protect you from risk
So, if you’ve decided that investing’s for you, the next step is obviously: what should I buy? Right? Hold up, hold up. We get into all that in our other learning guides.
First up, though, we think it’s really important to understand how your investments interact with each other… at Wealthyhood, we call this “building a portfolio”. 👷🏻♀️
All we mean by your “portfolio” is the collection of different investments you’ve amassed: how your pot of money is spread across things like cash in the bank, stocks, bonds, or real estate – or wackier stuff like classic cars or bitcoin.
OK. Time to introduce the key concept for this first session: correlation. 🔃 Correlation is a mathematical description of how linked two things are.
If, say, the price of kale always moves up and down in exactly the same way as the price of kombucha, then the two things are 100% correlated. If the two prices never move in the same way, then they’re 0% correlated.
The moment you own more than one investment, you’re building a portfolio (whether you know it or not). And you now have to consider not just the potential returns of each thing you’re buying but also how those returns may be linked. 🤔
Maths shows that the value of a portfolio containing several investments that move in uncorrelated ways will jump about less. In practice, finding investments that are truly uncorrelated is hard, but if you manage it, you should suffer from fewer and shallower drops in the value of your portfolio – and hence fewer sleepless nights. And you know how important sleep is. 💤
If you want to put this in more intuitive but less mathematically rigorous terms: don’t put all your eggs (or kombucha) in one basket. 🧺 Or, if you prefer, you can think of a balanced portfolio as meaning that any losses in one investment should be offset by gains in others.
Let’s get practical
Imagine you own £1,000 of Apple stock. If you’re suddenly given another £1,000, and you use it to buy shares in that other giant smartphone manufacturer, Samsung, you won’t have added much diversity to your portfolio.
It’s likely that both companies’ stocks will move in reaction to the same sorts of triggers – like the cost of silicon chips or the willingness of US consumers to spend money. But if you use that extra £1,000 to buy, say, a French water company’s shares or Canadian government bonds, you’ll probably have diversified quite a bit.
Correlation is a big reason why wealthy investors will pay such high fees for hedge funds. They’re not necessarily looking for massive returns from these funds; they’re looking for returns that are uncorrelated from things like the US stock market, where they’re likely to have plenty of money invested already.
So, to sum up, building a so-called diversified or balanced portfolio minimises your risk of losses compared to potential returns. 💪🏼
Stay tuned for Chapter 2, when we’ll run through a few examples of balanced portfolios selected by real-world investors.
Invest your money with confidence
When you invest your capital is at risk.