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The Importance of Investment Portfolio Diversification

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The Importance of Investment Portfolio Diversification

  • An excellent way to gain a strong foothold over your financial future, your portfolio can help you improve your chances of growth and success.
  • However, markets are unpredictable so your portfolio must be diversified.
  • Diversification is a technique that allows you to spread your investments across a range of companies, sectors and geographical locations so that you can minimise your risk.
  • Diversification can also help you preserve your capital and generate returns, while it offers that much needed peace of mind.
  • There are several ways you can go about it. You can diversify by company, sector and geographical location, while you can also diversify the assets themselves.

 

With the ability to guard your initial investment but also grow that capital to a level that would not have otherwise been attained, having an investment portfolio can help you gain a strong foothold over your financial future. But markets are often volatile and unpredictable. How can you protect your portfolio and assets from taking a big blow? You diversify.

An investment portfolio containing investments with little or no relation to each other, also known as low correlation, is in less danger of being heavily impacted upon by negative value fluctuations in any one company, sector, country or asset. One proven way to spread risk comfortably throughout your portfolio is to make sure you sufficiently diversify your investments. Diversifying your investment portfolio often enables falls in the value of one investment to be cushioned by rises in the value of another, unrelated investment.

Read along to discover the ins and outs of portfolio diversification and how to go about diversifying yours.

 

What is diversification and how does it work?

Investment portfolio diversification is a tried and tested technique that involves reducing risk by spreading investments across a varying range of companies, sectors, geographical locations and assets so that you can increase your odds of investment success. In practical terms, when the economy is growing, stocks tend to outperform bonds, however, when things are running at a slower pace, bonds tend to do better than stocks. As a result, by holding both stocks and bonds, you reduce the chances of your portfolio taking a big hit should markets swing one way or another, while at the same time, by spreading your capital amongst different investments, you do not have to rely on any single investment for all your returns.

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What are the benefits of diversification?

As expected, diversifying your investments is not an absolute buffer against financial losses, however, it remains a vital strategy for minimising risk. Some additional benefits include:

  • Minimising risk of loss: One of the most obvious benefits, if one investment performs poorly over a certain period, your other investments may perform better over the same period, reducing any potential losses since your capital is not centred on one specific investment. This also means that a diversified portfolio reduces the impact of market volatility. By owning investments across different classes, industry and enterprise-specific risk is also minimised.
  • Preserving capital: If you are not ready to risk it all, portfolio diversification can help you keep your capital safe. This is particularly important for those investors who might be closer to retirement or those who have just started investing and are looking for stability and playing it safe.
  • Generating returns: By selecting different investment instruments, you are more exposed to opportunities for return, most especially if you invest in different high-performing sectors. For instance, if you opt for mutual funds, you will benefit from investing in a mix of debt and equity. The same applies with fixed deposits since investors benefit from a fixed return and low risk.
  • Peace of mind: Ultimately, diversification offers peace of mind. With investments spread across a number of asset classes, you no longer need to stress about the performance of a specific investment.

Wondering whether your portfolio is diversified enough? Your financial advisor should always be your point of reference when it comes to managing your portfolio, however, one way of determining this yourself is to look at your current performance. Diversified investments do not move in the same direction at the same time, so if some of your investments are going up whereas other down, this is a good indication that your portfolio is diversified.

 

How should you go about diversifying your portfolio?

Diversify your company investments
Avoid investing all your money into a single company. In today’s uncertain economic climate, even the most prosperous of companies can suffer a fall in value or even fold. Always spread your investments across a number of companies and consider investing in those that operate in different market sectors. Make sure you conduct thorough research into any company you are interested in and always seek the advice of an independent financial advisor prior to making a final decision.

Diversify your sector investments
Investing in a range of different sectors brings the same advantages as investing in different companies. However, considering the various peaks and troughs that a wide range of sectors have gone through, you should spread your investments across sectors with low correlation. For example, if your investment in a company within the education sector suddenly experiences a dip in value, a rise in your gold investment could compensate for it.

 

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Diversify the geographical locations of your investments
A good way to minimise the effects of stock market movements is to spread your investments across different countries and regions. Placing your faith in the economic stability of a single country and the financial policies of its ruling government is risky. Here again, it is important to conduct research into the stock markets of different countries and get expert advice. Calculate the risks involved before choosing to invest abroad, while bear in mind that some less developed markets are more volatile than others and can be affected by systemic risks.

Diversify your assets
Make sure you have a good mix of varying asset types within your investment portfolio. There are many different types of assets, the primary being shares and bonds, which often have a low correlation to each other. You must also decide the level of risk you are willing take. Are you nearing the time you would like to draw upon your invested money? Then go for safer investments. If you are planning a long-term strategy, you may feel inclined to take more risk. Irrespective of your choice, remember that your portfolio must align with your financial goals.

What is over-diversification and why should you avoid it?

Just as lack of diversification can cause problems so can over-diversification. An over-diversified portfolio is one that is invested in a large number of different asset classes. While diversification can protect your investment portfolio from value fluctuations in correlated investments, over-diversification can lead to you not having enough invested money in a company or sector so that you can truly benefit from any growth. When there are too many investments, individual results are limited if one of them rises rapidly since that specific asset only represents a small fraction of the portfolio.

No matter how well diversified a portfolio is, risk can never be eliminated completely. The key is to strike the right balance between risk and return which will ensure that you still achieve your financial goals with the added piece of mind. Yet, for some investors, balancing a diversified portfolio is a complicated feat that requires experience in order to avoid limited rewards due to trying to mitigate the risks. Speak to one of our advisors to ensure that your portfolio is diversified enough so that you can reap the benefits and make your money grow.