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Email: Dwayne.Hameister@afanet.com.au
 
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Diversifying Investments

In financial circles, you will often hear of the importance of investment diversification. Its purported that a diverse investment portfolio will help reduce risk by allocating investments among various financial instruments, industries and other categories. The strategy aims to maximise returns by investing in different areas that would react differently to the same event. A simple example of diversification is provided by the proverb, dont put all your eggs in the one basket. The reason for this is if you drop the basket you will break all the eggs. If the eggs are in different baskets however, while there is more risk in losing one egg, there is less risk in losing all of the eggs.

In finance, if we look at an example of an undiversified portfolio that holds one stock, we can logically see the inherent risk value in that strategy. In financial markets, it is not uncommon for a single stock to go down by up to 50% in a single year. The same value drop is much less common across a number of different stocks in a diverse portfolio. Risk is minimised even further if the stocks are spread across a variety of industries, company sizes and types.

So what creates financial risk and how can it be reduced further? To start with, there are two main types of risk when you are talking about investing. The first type is market risk which is undiversifiable and associated with every economic entity. In this area, risk can be attributed to inflation rates, exchange rates, political instability, war and interest rates. This type of risk is not specific to any particular company or industry and it cannot be eliminated or reduced. This risk is one which investors simply must accept.

Diversifiable risk is also known as unsystematic risk and is specific to a company, industry, economy or country. It can be reduced through diversification. The most common sources of unsystematic risk are business risk and financial risk. The strategy of diversification seeks to minimise this type of risk as various assets across different areas will not be affected by market events in the same way. For example, if it is publically announced that airline pilots are going on an indefinite strike, then the price of airline stocks will drop. If you have all of your shares in this area, your portfolio will record a noticeable drop in value. If you have counterbalanced your risk by investing in resource or finance stocks, only part of your portfolio will be affected.

Still confused or unsure on how or where to invest? You are in good company with numerous others who are unsure or inexperienced with the financial system. That is why it is a good idea to come and talk to the team at AFA who have considerable skill and expertise in this area.