Investors aim to maximise their profits while minimising their losses. Given the uncertainty of the financial landscape, this isn’t always easy. Fortunately, by welcoming diversification into their portfolio, they stand a better chance of turning a profit.
What is investment diversification?
When you have all of your eggs in one basket, you stand to be hit with enormous losses if the value of said basket decreases. On the other hand, investment diversification fights against these losses by spreading out assets across different products or markets. For example, if you have investments in stocks and shares, you may wish to diversify your portfolio with other assets, such as bonds.
What are the benefits of diversification in a portfolio for investors?
There are many benefits of portfolio diversification for investors, including:
- Improves long-term goal achievements.
- Alleviates issues relating to market volatility.
- Allows less time spent watching the portfolio.
- Makes asset shuffling much easier.
- Helps secure capital.
What are the different types of diversification?
Diversification by location is when investments are made across different territories. For example, if every asset in your portfolio is tied to the UK financial market, you will face losses if the stock market tumbles. However, if you invest in US or European assets as well, you’re protected in the event of turmoil in the local economy.
Diversification by asset class can be split into “within” and “across”. There are a number of different assets in investing including real assets, cash or equivalent, fixed income, and equities – spreading your assets across these classes will help mitigate losses. When diversifying within assets, your portfolio will include funds, bonds, and industry investments.
How does it affect the risk and return of an investment portfolio?
Understanding your own risk tolerance is essential for succeeding as an investor, as the money you tie into an asset you have to be willing to lose completely. Through diversification, overall portfolio risk is lowered. This doesn’t mean there won’t be any losses, but it means that the losses are more likely to be balanced out by gains in a different asset class or location.
How can diversification help mitigate investment risk in a volatile market?
Some markets are more volatile than others, like forex and cryptocurrencies, because these markets are active 24/7. If you’re primarily a forex or crypto investor, you will have likely faced significant losses already. These losses can lead to high emotions, which can lead to poor choices, and this is never a good combination when investing.
Diversification is a great way to mitigate the risks when dealing with such volatile markets. For example, if a volatile market drops by 50% in the space of a day (not uncommon when dealing with cryptocurrencies), investments in a more stable market will help you to recoup these losses. Usually, what goes down tends to go back up, but having a diverse portfolio will prevent you from making rash decisions and withdrawing at a loss.
What is sector diversification?
Sectors refer to stock market companies that share similar qualities, and these are determined by The Global Industry Classification Standard (GICS). There are 11 different sectors in the UK stock market including:
- Materials
- Energy
- Healthcare
- Utilities
- Real estate
- Financials
- Industrials
- Consumer staples
- Communication services
- Consumer discretionary
- Information technology
Each of these sectors can be split into further categories. When it comes to sector diversification, it simply means having an investment in at least one of the main businesses from each of the 11 sectors.
Investment has the potential to be extremely lucrative at times, but there’s a downside that includes significant risk. Understanding how to diversify your profile will help to mitigate these risks, which will lower emotions and help to avoid rash decisions.
