Diversification helps lessen what’s known as ‘unsystematic risk’, such as reductions in the value of certain investment sectors, regions or asset types in general. But there are some events and risks that diversification cannot help with – these are referred to as ‘systemic risks’. These include interest rates, inflation, wars and recession. This is important to remember when building your portfolio.
The main ways you can diversify your portfolio
Having a mix of different asset types will spread risk because their movements are either unrelated or inversely related to each other. It’s the old adage of not putting all your eggs in one basket.
Probably the best example of this is shares, or equities, and bonds. Equities are riskier than bonds, and can provide growth in your portfolio, but, traditionally, when the value of shares begins to fall bonds begin to rise, and vice versa.
Therefore, if you mix your portfolio between equities and bonds, you’re spreading the risk because when one drops the other should rise to cushion your losses. Other asset types, such as property and commodities, move independently of each other and investment in these areas can spread risk further.
Once you’ve decided on the assets you want in your portfolio, you can diversify further by investing in different sectors, preferably those that aren’t related to each other.
For example, if the healthcare sector takes a downturn, this will not necessarily have an impact on the precious metals sector. This helps to make sure your portfolio is protected from falls in certain industries.
Investing in different regions and countries can reduce the impact of stock market movements. This means you’re not just affected by the economic conditions of one country and one government’s fiscal policies.
Many markets are not correlated with each other – if the Asian Pacific stock markets perform poorly, it doesn’t necessarily mean that the UK’s market will be negatively affected. By investing in different regions and areas, you’re spreading the risk that comes from the markets.
Developed markets such as the UK and US are not as volatile as some of those in the Far East, Middle East or Africa. Investing abroad can help you diversify, but you need to be comfortable with the levels of risk that come with them.
It’s important not to invest in just one company. Spread your investments across a range of different companies.
The same can be said for bonds and property. One of the best ways to do this is via a collective investment scheme. This type of scheme invests in a portfolio of different shares, bonds, properties or currencies to spread risk around.
Beware of over-diversification
Holding too many assets might be more detrimental to your portfolio than good. If you over-diversify, you may be holding back your capacity for growth as you’ll have such small proportions of your money in different investments that you won’t see much in the way of positive results.