What is diversification?
by Alexander Beard, on Apr 25, 2016 4:46:16 AM
If you’re new to the investment world, or even if you’re not, it’s likely that you’ve heard the term ‘diversification’ used in relation to your investments. However, you’re certainly not alone if you don’t have a clear idea of what the word actually means for your investments. Read on, and learn everything you ever wanted to know about diversification, but were afraid (or didn’t have the time) to ask!
As a starting point, you’re most probably aware of the proverb that warns you about putting all of your eggs in one basket. In essence, that’s what diversification is all about. Diversifying means creating a portfolio that includes multiple investments, which in turn reduces risk. Think about it: if you invest only in stock issued by one company, your portfolio is liable to sustain serious damage should that company’s stock suffer a major downturn. Splitting your investment between stocks from two or more different companies reduces that risk.
A second method of diversification is including both cash and bonds in your portfolio. This reduces the risk by giving you a short-term reserve of cash investment. Ensuring that a segment of your assets is in either cash or short-term money-market securities is a good way of reducing the risk to your portfolio. Cash can be used in emergencies, and short-term money-market securities are useful if an investment opportunity crops up or if you need more cash for payments than usual, as they can be liquidated straight away.
Don’t forget that asset allocation and diversification are interlinked, as diversifying your portfolio is achieved through allocating assets in a particular way. If you’re looking to invest aggressively, you might opt for 80% stocks and 20% bonds, for example, and vice versa for a more conservative investment.
Whilst diversification might seem like a simple goal, there are still pitfalls which need to be avoided. Any decisions you make about diversifying should be well judged, and many investors are careful not to over-diversify their portfolio. Too much diversification (or ‘diworsification’ to use a recently coined term) means your investments are unlikely to have an impact, leading to a negative effect on your returns.
We’ve only scratched the surface of diversification here though and, when all’s said and done, there’s no one-size-fits-all method of achieving a diversified portfolio. Each investor will need to look at their time horizon, tolerance for risk, investment goals, means of finance and experience in investment to work out how to best diversify your portfolio to suit your needs. If you feel overwhelmed at the choices available, or if you’re just someone who prefers to delegate such decisions, then we can, of course, help with formal guidance and advice.