We believe investors should always consider one of the most important maxims of investment – diversification.
Diversification is the strategy of combining a number of different investments together in a portfolio to reduce investment risk. In simple terms, to avoid putting ‘all your eggs in one basket’.
For example, by spreading your investment portfolio across several different assets and markets which match your required investment objectives, it is possible to obtain the return that any one of them can offer but face a much lower risk.
Although one asset may fall in value it is less likely that they all would do so simultaneously. Hence, the possibility of loss can be reduced when you hold a number of assets. Diversification can be achieved in a number of ways. Below are some of the most common methods by which you can diversify your investment and thereby reduce investment risk.
Different assets react to market movements in different ways. For example the influences that move the value of an equity may have no effect on the return on a government bond.
This lack of correlation means that by holding a mixture of such assets in a portfolio the investment risk can be reduced through this diversification.
Assets also react to market developments in different ways depending on their geographical location. This is because economic cycles, currency valuation and industrial developments generally vary from country to country. Thus, by investing internationally, it is possible to avoid putting all your eggs in one country basket.
Many companies and industries are subject to different business risks – for example, quality of management, profitability, market conditions, to name but a few.
Much of this risk is diversifiable by investing in a range of stocks in different market sectors.
For example, the price of technology companies, which are typically growth oriented, behave differently to utility companies which are more defensive in nature.
Typically, the greater the amount of stocks in your portfolio the greater the diversification which in turn leads to lower risk.
A simple way to help reduce risk is to invest for the long-term. For example, in spite of their volatility, equities held over longer time periods tend to provide positive total returns.
Taking a long-term view allows your investment longer to grow and this should make up for any short-term fluctuations.
- Diversification is a strategy used to minimise investment risk by investing across a number of different investments.
- Diversification can be achieved through combining different assets, different stocks,investing internationally and taking a medium to long-term view when investing.