Why you should consider portfolio diversification

Posted on: 22nd July 2020 in Investments

As the old saying goes, variety is the spice of life.

But did you know that variety is also the key to a successful investment strategy?

If you have read anything on investments, you have no doubt heard the term ‘portfolio diversification’.

There is a reason why you hear the term so often. Having a diverse portfolio can help combat one of the biggest drawbacks to investing – risk.

In this article, we take a closer look at one of the strategies used by investment professionals to build successful portfolios.

Balancing risk and reward

We take risks to reap the rewards. For some, that could mean leaping from a plane at 13,000 feet. The risk is jumping from the plane, and the reward is the adrenaline rush you get.

Before we act, our brains calculate whether the reward is worth the risk. Some are more risk-averse than others; let’s take roulette as an example.

Putting all of your chips on one number may net you the highest return, but it comes with a high risk. Some people will see this as a risk worth taking, while others take another approach.

Those who are more risk-averse might spread their chips across multiple numbers. They will still see a return if the ball lands on one of their numbers, but the risk is much lower.

Portfolio diversification is the equivalent of spreading your chips. It is a strategy used to balance the risk/reward ratio of your investments.

Having a diverse portfolio means having a mix of investments. That way, better performing investments can balance out those that are not doing so well.

Real-world application

There is an infinite number of ways to achieve a diverse investment portfolio. How much risk you are willing to take and your investment goals will determine how you diversify.

Here are some things to consider.

Assets

When you invest your money, you invest in an asset. Some of the common assets people invest in include:

• Stocks – these are one of the more common assets. Shares or equity are purchased for a company listed on the stock market
• Commodities – these are goods which are used for production. Gold is also a commodity
• Bonds – these are essentially a loan to the government or a company. The domestic economy of a country mainly influences bonds, and they are considered a safer investment
• Real estate – this could be anything from property to agriculture

Investors will typically pick assets with a low correlation. 

Low correlation means two (or more) assets that perform differently from one another. By using this method, losses in one asset class can be offset by another performing well.

Location

A country’s economic situation, stock market and government policies can all affect your investments.

By spreading your investment around the world, you can further diversify your portfolio. 

Investing in different locations around the world can help lower risk, but in some cases, it can increase it.

The UK, US and other developed markets tend to be more stable. However, emerging markets, such as India and Russia, can be more volatile. Increased market volatility brings with it increased risk to your investments.

Sector

The key is not putting all of your eggs in one basket. 

Let’s say you invest in an oil company. Your investment is going well, so you decide to buy more shares in the company.

There could be an event that causes the oil company to perform poorly. At this point, the value of your shares would start to tumble.

By investing in different sectors of an asset, you can offset some of the risks. Ideally, it’s best to avoid sectors that are connected.

An example of this could be if you invest in gold and the leisure industry. If the price of gold suffers, it shouldn’t affect your leisure investment. By investing like this, your portfolio is more protected from dips in different sectors.

Company variety

The same logic that we apply to the asset and sector choices can be applied to individual companies.

It only takes one wrong business move by a company, and the value of their shares could drop. Worse still, the company could go bust.

Rather than investing everything in one company, it is good practice to hedge your bets. Spreading your investments across different companies is a good way to avoid potential losses.

Beware of the cons

Diversifying your portfolio is certainly a powerful strategy, but it doesn’t guarantee success.

There are pros and cons to everything in life – a diverse investment portfolio is no different.

There is such a thing as being too diverse. Spreading your money too thinly over a large number of investments may not yield noticeable growth.

Holding too many investments can also be a logistical nightmare. Having to manage a portfolio with too many holdings can be complicated and time-consuming.

You need to also factor in costs. Buying and selling holdings will incur brokerage commissions and transaction fees.    

Successful investing requires good knowledge and understanding of the markets. Optimising a portfolio and finding enough time in the day to manage it can be challenging, especially for new investors.

If you are new to the world of investing, speaking with a professional can get you off to the best start. Even seasoned investors can benefit from speaking with a financial adviser.

We have been helping clients for over 20 years to achieve their financial goals. To find out how we can help you achieve yours, contact us using the form below.