You know the saying do not put all your eggs in one basket, right? That summarizes what diversification is all about when it comes to investing.

Diversification is an investment strategy you can employ to lower your overall risk. It entails you not investing all you have in one asset class, sector, or company as the case may be.

Since each asset class performs differently under different economic conditions, different investment options in a portfolio will inadvertently keep you from losing all your investment when one sector is underperforming.

We will discuss ways to diversify your portfolio in a smart manner

Have a mix of different Asset classes

One way to spread your investment is by having different asset classes in your portfolio. These asset classes could include Equity, Derivatives, Commodities, ETFs, REITs etc. we shall discuss them in below:

• Equity is also known as shares in a company. When you buy shares of a company, you become a co-owner and you share in its profits and losses.
• A bond is a loan to the government or a company. Sometimes when government or companies need a loan, they go to investors (i.e the public) as it could be a cheaper alternative than going to Banks.

In Kenya, the tenor of bonds ranges from 2 to 30 years making it ideal for those going into retirement. In Kenya Bonds are auctioned every month by the Central Bank of Kenya (CBK) after which they are listed on the Nairobi Securities Exchange (NSE).

So if you don’t buy from the CBK you can buy from the NSE.  Almost all Bonds issued in Kenya have a fixed interest rate- meaning you earn the same interest till contract expiry; and coupon interest is paid every six months.

• Commodities refer mainly to natural products or goods. Commodities worth diversifying your portfolio with include: Oil, copper, Tin, Gold, Wheat, and Silver etc.
• Derivatives are financial contracts that are based on an underlying asset. Derivatives include Options, Futures, Swaps, and Contract for Difference (CFD), etc. Derivatives can be used to hedge risk in your portfolio and also to speculate.

A popular way to trade CFDs is via forex brokers that offer forex & CFD trading. It is important to know that online forex trading in Kenya is regulated by the CMA & there are only six CMA licensed non-dealing Online FX brokers.

These brokers also offer CFD trading on instruments other than forex. But CFDs are more suitable for the forex market than for stocks because the volatility in stocks is much higher & can lead to higher losses for speculators when trading on margin.

Investors should only use Equity derivatives to hedge risk and not for speculation; and any speculation should constitute just 10% of your investment portfolio. The NSE has a derivatives market called NEXT where you can access various derivatives.

• Exchange Traded Fund or ETF is an investment vehicle which invests in a basket of diverse shares, or tracks and attempts to replicate the performance of an Index such as the NSE20, NSE25. ETFs are very flexible and can be designed to tract almost anything.

An example of an ETF listed on the NSE is the ‘ABSA New Gold’ ETF that invests in Gold mining industries; so buying into it ensures you have exposure to Gold.

• A Real Estate Investment Trust (REIT) is an investment fund that invests in income-generating real estate properties. REITs are traded on the NSE. An example of a listed REIT as seen on the NSE is ILAM FAHARI I-REIT. When you buy shares of a REIT you benefit from being a landlord without actually owning a house.

Have a mix of Bonds of various quality

Generally Treasury Bonds issued by the Central Bank of Kenya are safe but then you should also add corporate bonds to your portfolio. Corporate Bonds are issued by Companies so they are not as safe as government bonds.

When investing in corporate bonds, pay close attention to their credit rating. The S&P's AAA rating denotes the highest level of quality, while AA+ also denotes the next highest level of trust quality or organization’s repayment ability. You should have both AAA and AA+ rated bonds in your portfolio.

Have a mix of Bonds with varying Tenors

One way to diversify your investment portfolio is to furnish it with long and short tenor bonds. The duration of bonds is expressed in terms of years. The NSE has the following Bond tenors:

• Two year bonds
• Five year bonds
• Ten year bonds
• Fifteen year bonds
• Twenty year bonds
• Twenty five year bonds
• Thirty year bonds

The tenor of the bonds matter because inflation could erode the value of interest earned on bonds after a long period. Government always issue bonds with higher interest rates when inflation rises so getting short tenor bonds means after contract expiry, you can buy another bond with a higher interest payment. However it is good to have a mix of short and long tenured bonds.

Have a mix of Equity from different sectors

You can also diversify your portfolio by investing in stocks of companies across different sectors. The idea is that if one sector is doing badly, gains in others will cover up for it.

Examples of some sectors/stock listed on the NSE include:

• Agricultural Sector: Sasini Plc. Williamson Tea Kenya Plc. etc.
• Energy Sector: Kenya Power & Lighting Plc. Total Energies marketing Kenya, etc.
• Banking: Absa Bank Kenya Plc. Stanbic Holdings Plc. etc.
• Construction: Bamburi Cement Plc. ARM Cement Plc. Etc.
• Telecom: Safaricom Plc.
• Investment services: Nairobi Securities Exchange Plc.
• Insurance: Britam Holdings Plc. CIC Insurance etc.

Have a mix of different Company stocks

Not every listed company will be a mega company or a blue chip company. Some are startups and some don’t post as high a profit but they should not be ignored.

Some of these companies below the radar actually have good prospects and fundamental analysis will reveal this. The idea is to invest in both blue-chip and medium performance companies for diversification.  

When picking stock from a particular sector don’t focus one just one company in that sector. For example in the Manufacturing & Allied sector you could pick different company stocks like British American Tobacco Kenya Plc., East African Breweries, Mumias Sugar etc.

However, before investing in a company stock, you should do your fundamental analysis to arrive at intrinsic value via ratios such as the price to earnings ratio (P/E) of that company.

The P/E ratio is the relationship between a company's stock and earnings per share. It gives investors an understanding of the value of the company. A high P/E ratio for a company might give investors the idea that the company is overvalued or its shareholders are expecting growth in future.

Diversify by Correlation

Finally, you should diversify stocks in your portfolio according to correlation. Correlation is the relationship between two stocks and their price movement. There is positive and negative correlation.

Positive correlation is said to happen when two stock prices move together in tandem and have a correlation coefficient above 1. When two stock have positive correlation a fall in price of one will mean a fall in price of the other and this is against the philosophy of diversification.

A negative correlation on the other hand occurs if one stock goes up and the other goes down. The correlation coefficient is always below 1. For negative correlation a fall in price of one stock will mean a rise in price of the other one and this is what you need to diversify your portfolio.

Correlation calculators are available online to help you calculate the correlation coefficient. The key take away is that stock in your portfolio when compared with each other, should have negative correlation to make for diversification.

Keep your risk low

As an investor, you must diversify your investment portfolio to minimize risk and make as much profit from many sectors. However, diversification goes beyond rhetoric. It should be a well-thought process ensuring that you understand the industry and company you are putting your money into.

You should spread your money across different companies, and financial instruments such as bonds, stocks, currencies, etc.