There is no denying diversification is needed with every investment. Portfolio diversification is a foundational concept in the world of investing and it is in agreement that whilst it doesn’t guarantee to protect you against or provide certain profit, diversification is a crucial element when seeking to achieve any form of return.
So, what is diversification and why do we need to include it in an investment portfolio?
What is diversification?
Diversification is a tactic used by most financial planners and fund managers. It is an investment management strategy that blends different asset investments across a number of industry or sectors in a single investment portfolio. Diversification is one of the most common investment management strategies and is brought in for two distinct reasons:
– A variety or range of investment options can yield a higher return in investment.
– A diversified investment portfolio should reduce the level of risk they are exposed through investing in several different sectors and asset types.
The Idea of Risk
The only universal element to investing across the many financial markets is the notion of risk and how much risk you can expose yourself to.
For those who are unsure what the idea of risk and how it affects your investment, it is essential you gain an understanding of what it is and what it means for your investment. In short, there are a select grouping of factors that determines the level of risk you can be exposed to. These include, how much you want to invest, the sector you want to invest in, your investment strategy, the timescale for returns and most importantly, the capital you have to support your investment.
Understanding your level of risk is a critical component to consider when undertaking any level of investment. To understand what risk is and how it affects your investment, investors should be aware of the two types of risk that are associated with any investment, unsystematic risk and systematic risk.
Systematic risk – also commonly referred to as ‘market risk’ – can often be un-diversifiable in that it typically pervades the entire investment landscape. Examples of this include the 2008 financial crises and global pandemic. On the other hand, unsystematic risk is diversifiable either through region, country, industry or sector.
So how can you diversify your investment options?
There is no golden formula to diversifying your investment portfolio. As investment strategies differ from fund to fund, the best way to diversify your investment portfolio will naturally change from person to person. However, there are a number of common elements which can be utilised:
Choose a range of assets
One of the most successful ways to minimise risk while ensuring high potential returns is to spread your investment across a number of varying asset options. Although certain asset types provide investors with fast and relatively reliable returns, having a collection of different assets will help you spread the level of risk across a larger area.
The theory behind this approach is simple. Each asset value can move in different ways due to market trends and often for a number of external and internal factors. Due to the nature of the stock market stocks will naturally react to strong or weak performance of a company or external influence from other investment trusts trying to short the price. Bonds are influenced by interest-rates having a range of assets in your portfolio could not only help you see healthy returns, but also protects you against risk.
Diversify by sector or industry.
Diversifying by sector or industry is the natural step from choosing a range of assets. While investing in a variety of assets will decrease the level of risk associated with an investment portfolio, this can be aided by diversifying the sectors or industry you are investing in.
Different markets and sectors are not always correlated or related to each other. Once you have chosen the assets you want to include in your portfolio, you can pursue these across a number of different industries to ensure you are protected if external factors influence a particular sector. Examples of a diverse portfolio by sector can include, manufacturing, air travel, hospitality and insurance.
The theory behind this investment strategy is simple. If you invest in several sectors which are not related, if one experiences a downfall, a non-related sector should not be impacted and therefore continue to grow in value.
Buy shares in a lot of companies.
Now you have chosen your asset class and the industry you want to invest in, it is recommended you invest in a number of companies instead of placing all your eggs in one basket.
If you buy shares in a single company and they experience bad times/ go bust, your investment will still be at risk even if you diversified across several industries. If you invest shares in a multitude of companies, your investment will be far safer if this happens.