Don’t put all your eggs in one basket
Portfolio diversification is the foundational concept of investing. It’s a risk management strategy of combining a variety of assets to reduce the overall risk of an investment portfolio.
Traditional wisdom says: don’t put all your eggs in one basket. By ensuring your portfolio is well diversified across different asset classes, geographies, styles and size, you spread your risk exposure. If something goes wrong with one security, it only accounts for a small proportion of your investments and therefore won’t be too detrimental to your overall wealth.
The ultimate aim of portfolio diversification is to lower the volatility of a portfolio because not all asset categories, industries or stocks move together. By holding a variety of non-correlated assets, you can reduce specific investment risk.
Diversification is also important because investing in markets can be volatile and unpredictable. In practical terms, diversification is holding investments which will react differently to the same market or economic event. It’s also your best defence against a single investment failing or one asset class performing poorly.
Smoothing out returns
When the economy is growing, stocks tend to outperform bonds. But when things slow down, bonds often perform better than stocks. By holding both stocks and bonds within your portfolio, you reduce the chances of your portfolio being subjected to corrections when markets swing one way or the other.
Diversification also safeguards you against adverse market cycles and reduces volatility. In other words, by owning a large number of investments in different industries and companies, industry and company-specific risk is minimised. This decreases the volatility of the portfolio because different assets should be rising and falling at different times, smoothing out the returns of the portfolio as a whole.
Different asset classes
To diversify well, you need to invest across different asset classes and within different options in an asset class. If most of your money is in one or two asset classes, it may be prudent to consider other asset classes. Then, within each asset class, make sure your money is invested across the different options available. The three simple ways to diversify your portfolio broadly are by investing across asset classes, within an asset class and internationally.
Setting the right asset allocation for your financial goals and personal specifications depends on a number of factors. These include your investment time horizon and what you are going to use the money for. If you want to grow the money, you will need to take on some risk; if you are looking to preserve it, you will need to limit risk.
Time horizon and goals
Diversification is also important regardless of your time horizon and goals. Any time you’re investing in the stock market, you should aim for a diversified portfolio. As your goals or time frames change, the levers to shift should be determined by how aggressively that diversified portfolio is built. Investments allocated to a long-term goal can lean more heavily on stocks, for instance, than those geared towards near-term goals.
An easy way to determine if your portfolio is diversified is by looking at your current performance. Diversified investments won’t move in the same direction at the same time. If some of your investments are up while others are down, you’ve got diversification.