How does diversification work?

We all know that diversification is key when planning a financial portfolio. It mitigates risk by spreading your investments out over a variety of areas.

Why diversify?

“Diversifying your assets helps spread risk because you’re reducing the likely potential for losses. If you had all your money invested in one asset, sector, or region, and it began to drop in value, your investments would suffer. By investing in assets that aren’t related to each other, while one part of your investment portfolio is falling in value, the others aren’t going the same way. Some assets will actually go up in value when others decrease.” *

This can be a daunting task even for the most consummate of investors.

Let’s take a closer look at diversification and the various ways in which a portfolio could be diversified.

Ways to Diversify your Portfolio

Diversify with Multi-Asset classes

Asset classes are collections of similar investments that also behave similarly in the market.

To benefit from diversification, you need to invest in assets that behave differently from each other. Different assets have negative correlation to each other, meaning, when one loses value another increases in value.

Asset classes – asset allocation refers to the process of dividing your investment between different asset classes such as Cash, Bonds, Shares/Equities and Property etc.

Asset diversification

example of asset diversification

  • Cash/money market – These are cash funds invested in cash and short-term deposits. They generally achieve a better rate of return than savings accounts and bank deposit accounts. (These are the lowest risk).
  • Bonds/fixed income – These are considered stable low risk investments. Basically, bonds are issued by companies and governments to raise money. It is in essence a loan with a predetermined pay back day and fixed amounts paid at regular intervals.
  • Shares/Stocks/Equities – These are shares of companies that are traded on the stock market. This type of investing is higher in risk, but returns are also generally higher. Money is made when stocks or shares increase in value or when dividends are paid to shareholders.
  • Commodities and property – These are tangible or physical goods traded like precious metals (gold, silver, platinum, palladium etc) and agricultural produce (wheat, maize, coffee etc) and minerals like crude oil. Property usually refers to commercial property investment. This in investing in real estate companies or even buying properties to generate rental income.
  • Alternatives – These do not fall into regular asset class categories such as hedge funds, venture capital, cryptocurrency etc.

Diversify by sector

This means investing in a variety of sectors to spread risk e.g. financial sector like banks and fund managers, telecommunications like Huawei, property, energy like solar companies or utilities, information technology like Microsoft or Alphabet, healthcare like pharmaceutical companies, consumables like cereals.

This will help mitigate the risk if one of the sectors performs badly.

Sector diversification

example of sector diversification

Diversify by region

Different economies are affected by different factors. It seems logical to spread your risk over several economic regions. e.g. US markets, Asia markets, Europe and UK markets, emerging markets etc.

This means investing in companies based in different regions or different stock exchanges like the Nasdaq, FTSE, S&P etc

Diversification across regions

example of diversification across regions

Diversify across a range of different companies

This approach invests in different companies which could operate in different sectors and be based in different regions.

There is also the possibility of, in the attempt to ensure you have a diversified portfolio, you could overdiversify. It might not cause you to lose money but may be holding back capacity for growth.

Also consider the time factor of your investments – long term investments could be invested in different funds to short term investments.

Whilst trying to diversify your portfolio can be confusing, it is always best to seek the advice of a financial expert to advise on the best investment according to your risk appetite and individual financial circumstances.

*https://www.which.co.uk/money/

Please note, the above is for education purposes only and does not constitute advice. You should always contact a financial adviser for a personal consultation.

No liability can be accepted for any actions taken or refrained from being taken, as a result of reading the above.

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