Naive diversification

Investing exposes us to many different risks. These are inevitable – without them, returns wouldn't be possible!

Antonio, in The Merchant of Venice by William Shakespeare, explains his strategy: '[…] I thank my fortune for it: my ventures are not in one bottom trusted, nor to one place; nor is my whole estate upon the fortune of this present year.' Antonio spreads his goods among different ships, headed toward different places, which is a form of diversification.

Diversifying investments is a golden rule to contain risk. Diversification means spreading investments across different assets to avoid concentrating all your savings in one type or sector. This doesn't eliminate risk entirely, but it helps contain it and ensures more stable returns.

Returns vary due to many factors—industry, geography, individual company traits. Some sectors (like tech, bare necessities, or luxury goods) may perform well in one year, while others lag, and vice versa the next year.

A diversified portfolio means that poor returns in one area can be offset by gains in another. To diversify effectively, include a variety of financial instruments whose returns move differently over time: not only government securities, but also shares, bonds, investment funds, assets in different sectors and countries, possibly in different currencies.

When the returns of multiple investments move in the same direction, they are said to be correlated. Good diversification involves holding uncorrelated assets. A common mistake is naive diversification: believing that we have adequately diversified our investment portfolio, when in fact we have not carefully considered the characteristics of the instruments we hold and have not properly spread the risks associated with them.

Example

You have accumulated some savings in your current account and want to invest them to earn returns without taking on too much risk: you prefer modest returns rather than high gains with the risk of losses that could reduce your capital. Initially, you consider buying a security that you have heard good things about, for example, a bond from a telecommunications company. But then you think it's better to divide the savings you want to invest into three different parts: one in a telecom bond you've heard good things about, one in another telecom bond, and one in government securities. Is this good diversification? Is it wise to invest two-thirds of your savings in the same sector and in only two companies? Does your portfolio truly include instruments that are different from one other?

Just increasing the number of investments isn't enough. Watch the video to learn more about naive diversification.

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