What is diversification?
Diversification is a way of reducing potential risks and increasing potential returns by spreading your investments across different assets.
Diversification is financial jargon for 'don't put all of your eggs in one basket'. A core principle of investing, it champions spreading money across different types of investments, based on the logic that if one drops in value, the others could help to cushion the blow.
Why diversify your investments?
The primary goal of diversification is to reduce risk. When you hold several investments that exhibit differing characteristics, you can breathe easier knowing one particular, unpredictable event shouldn’t singlehandedly threaten your financial future.
No matter how solid an investment appears, it could go through a rough patch. Anything from changing government policy to wild speculation can send valuations tumbling, making investing a volatile and unpredictable business, and by spreading your investments you could limit the chance of your hard-earned savings suddenly withering away.
» MORE: All about investing
How to diversify your investments
A successful diversification strategy hinges on the investments in your portfolio having limited correlation. This inevitably requires abiding by the following approaches:
- Invest across asset classes: Each asset class (a fancy way to say a grouping of investments with similar characteristics) tends to thrive in different environments. Shares, for example, generally excel when the economy is booming, whereas bonds and assets such as gold usually fare better when confidence declines, spending dries up and interest rates are cut.
- Diversify within asset classes: Shares, bonds and other asset classes may each be lumped into the same box, but that doesn’t mean they behave alike. Cyclicals, for instance, such as recruiters, housebuilders, airlines and carmakers, traditionally prosper when there’s lots of money floating around and struggle during a recession. Meanwhile, defensive companies in the business of supplying necessities should experience stable demand regardless of how the economy is performing.
- Think globally: Not all economies move in tandem, and, like asset classes, it’s possible for one to flourish while another stutters. International reach can be achieved by purchasing overseas assets on investment platforms or simply by investing in the UK’s biggest companies, many of which have operations all over the globe.
- Rebalance: Diversification is not a one-time task. Over time, it’s likely that some of your investments will grow faster than others. To avoid your savings pot gradually becoming skewed towards the best performers, and out of sync with your original goals, your portfolio should be periodically rebalanced back to its original asset allocation.
Achieving the right level of diversification can be challenging, time-consuming and expensive. Often the easiest, most cost-effective way around this is to invest in funds with contrasting strategies and characteristics.
» MORE: Investment strategy examples
Example of diversification
Frank believes electric vehicles will one day be a common fixture on roads and is eager to cash in on this trend.
His first instinct is to follow the herd and buy shares in Tesla. Closer analysis convinces him otherwise. Tesla is not the only manufacturer of electric cars, and it faces lots of competition from traditional automakers with significant financial muscle and decades of experience adapting to change.
Rather than try to pick a potential winner, Frank opts to spread his bets by investing in an exchange-traded fund (ETF) tracking the Stoxx Global Electric Vehicles & Driving Technology index: a portfolio composed of 85 producers of electric cars, batteries and other essential parts. This investment enables him to cover all angles in the electric-vehicle race, as well as benefit from other technological breakthroughs poised to reshape the global economy – the index’s constituents include chipmakers, semiconductor and industrial robot manufacturers.
Finally, Frank decides to add a defensive component to his portfolio, investing in a broad array of funds targeting less racy, non-tech equities and other asset classes to shield himself against a downturn in economic activity.
Remember, investments can rise and fall. You may get back less than you invest. Past performance is no guarantee of future results.
This is an informational guide and does not constitute advice. The content does not take into account personal, financial and tax circumstances of the reader. Before proceeding with any kind of investment, qualified professional advice should be sought.
Image Source: Getty Images
Daniel is a freelance finance journalist. He has written and edited news, deeper analysis features, and opinion pieces for the Financial Times, Investopedia and the Investors Chronicle. Read more