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Investors can choose from countless products, markets, and strategies. When markets are buoyant, investment can produce excellent returns with little risk – however, in sideways or downward movements, a previously profitable investment product can quickly build large losses.
Diversification mitigates the likelihood and impact of moving markets by balancing products to spread the risk.
The concept is similar to putting all your eggs in one basket. If you had a portfolio comprising one specific stock, and the trading company were to become insolvent or steeply devalued, the hit would be dramatic without any safeguards in place.
Regardless of the market climate, investors should ensure they do not keep all their capital in one asset class, sector, or product type.
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The Importance Of Portfolio Diversification In Investment
The theory is that a mixed, balanced portfolio with a range of assets will produce higher returns, but the primary objective is to reduce overall risk. There are several reasons this is a basic requirement for several reasons:
- Investors cannot predict which shares will rise or which assets will appreciate. Even the most seasoned institutional investment managers can make mistakes – the markets can shift with little warning and buck trends.
- Picking ‘opposite’ assets can mean any loss is mitigated or balanced by increased profit from another element of your portfolio. Where one stock falls, the other gains, reducing the potential to make irrecoverable losses.
- Spreading investment across sectors, assets, and products reduces your exposure to losses if one market or sector declines. For example, if every portfolio asset is linked to a fintech company or a pharmaceuticals stock, and that part of the market falls, every investment in the portfolio is affected.
Diversification also relates to geographic considerations. Recession and economic stagnation can impact many sectors and create an overall negative performance.
Investors can spread their capital across countries, invest in alternative currencies, or select stocks they have sufficient knowledge of in emerging jurisdictions with a greater potential for strong long-term growth.
They might also use fixed-income products, such as index-tracking products, but with different underlying indices or stock exchanges. If the London exchange drops, but the Tokyo exchange remains unaffected, the overall outcomes are considerably better than if every product was linked to the former.
Practical Tips For Effective Portfolio Diversification
It is easy to spot the signs of a market collapse or a financial crisis in hindsight, but at the time, or just before markets are poised to dive, few investors have the knowledge, accurate forecasting or expertise to predict movements correctly.
Examples include the internet boom, followed by the dot-com collapse, or the Coronavirus pandemic, where some sectors would thrive, and others struggle to survive.
Astute investors use established strategies, technical and fundamental analyses, discipline, and diversification to protect themselves from unnecessary risk and avoid making sudden, knee-jerk emotional decisions based on unfavourable price movements.
By the time investors can actively respond to unexpected changes in the market, the damage to their portfolio value is already done, so diversification can be designed to support the investor’s required risk exposure level but prevent losses from becoming disastrous.
Choosing investment products with mixed risk
Many beginner investors focus solely on equities, but this is just one of many possible products. If you prefer equities, it is important to spread your assets over sectors and stocks.
Options could include investment in a business sector you know well but in different locations or countries, picking equities in varied industries, or investing in opposing sectors, such as energy vs solar power.
Investors can also blend stocks with the following:
- Exchange-traded funds (ETFs)
- Property or property-related investment trusts
- Commodities
Although investing only in markets you know and understand can be perceived as risky, the opposite argument is that you will likely have a closer grasp of the factors that will influence your asset values. However, diversifying globally can reduce the risk.
It is also important to try and avoid over-diversification, where you invest in so many contrasting products or sectors that it is impossible to track and monitor every asset with sufficient detail to make informed judgements.
Diversifying with index funds
Index funds track stock market indices and have a lower risk profile. The value of the fund and the returns paid out rely on the index’s performance, so it is less exposed to a loss.
Securities can be a long-term diversification tactic and act as a hedge against market instability, trying to match the index’s performance rather than investing in one specific asset or sector.
Fixed-income bonds and index funds are normally relatively cheap in management fees since the product monitors and follows the index, with minimal active management required.
A possible drawback is that a passively managed investment is not always the optimal way to achieve above-average returns, particularly where markets are unpredictable. Active management costs more in fund administration fees but can improve your prospects when the economic climate is challenging.
Gradual portfolio expansion
Another way to build on a well-diversified portfolio is to keep adding new products to the mix periodically rather than picking a few and leaving them to run indefinitely.
Some investors also advocate for slower investment, investing lower values over time, with a reduced risk element than simultaneously investing all your available capital. There are potential benefits, such as being able to invest in shares or stocks when prices are low and reducing your new investments when prices rise.
Creating an exit strategy
One of the fastest ways to lose money in an investment is to buy and hold a product long after it has descended on a downward trajectory – although there may be situations where holding your position and waiting for the trend to reverse is the only viable option.
However, investing on autopilot without specifying the conditions that mean you need to exit can be dangerous.
Regardless of the size of your portfolio, staying up to speed with market conditions matters, providing you with information to compare to your investment strategy and exit approach and making calculated decisions about when it’s time to hold and when it’s time to move.
Monitoring fees and commissions
A diversified portfolio carries a lower risk and in-built protection against market downturns. The pitfall is that any actively managed products come with costs. Those fees will likely increase if you have a broad array of assets, cross-sector investments and global financial products.
Fund managers might charge per month or levy transactional fees. Still, you need to know what you are paying to ensure this isn’t eroding your returns or so high that your portfolio would need to perform unusually well to be profitable.
Low-cost fund management is rarely the best, but every investor needs to keep an eye on commissions and costs.
How To Diversify A Portfolio FAQ
Diversifying means you spread your investments across asset classes, stocks, or sectors, reducing the risk of losing everything if a market or sector slumps. Diversifying involves multiple ways, but this technique is known to lower risk and protect your portfolio from irrecoverable losses.
Without diversification, you may lose all the capital invested if a security or asset falls or becomes heavily devalued. Diversifying brings down the total risk profile associated with a portfolio while safeguarding returns and often providing greater profitability.
Yes, diversifying across too many products can make it impossible to manage a portfolio accurately or know with certainty how every related index, market or equity is performing. Investors must also carefully select diversification assets since introducing a new investment in an already successful portfolio may inadvertently increase risk or lower anticipated returns.
Investment advisers begin a diversification exercise by evaluating a portfolio’s current components and assessing where the greatest risk lies. For example, that might be because every asset is within the same business space, asset class, or country.
They recommend assets with a clear differentiation, where negative impacts against one asset are less likely to affect another. Over-diversification can occur if you have an ideal balance of securities and upset that balance or add new securities to your portfolio that are too closely linked to pre-existing investments.
The most common risk measurement approach is to use standard deviation. This calculation looks at how close actual returns are to expected returns – and how big the variation is between anticipation and performance.
Larger deviations mean the portfolio is at higher risk because the outcomes are less certain and further away from the expected results.
No magic formula will guarantee against losses, and the right asset mix depends on your investment objectives, capital, knowledge and aims.
Some investors recommend splitting assets between 60 per cent in stocks and 40 per cent in fixed-income products such as index funds. Still, the correct solution relies on detailed risk calculations, forecasting and market monitoring.
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