Diversification is a word that seems to get tossed around a lot in conversations around savings and investment. We hear it often, but what does it mean?
Put simply, diversification is a risk management strategy that mixes a variety of investments within a portfolio. Through having different kinds of assets in a portfolio, the goal is to obtain higher long-term returns and lower the risk of any sole holding. Essentially, you are hedging your bets.
By smoothing out the risk of each investment within your portfolio, you’re aiming to neutralise the negative performance of some investments with the positive performance of others. Though your investments will only benefit when the different investments are not perfectly correlated, you want them to respond differently, often in opposition to one another, to market influences.
One drawback to be aware of, though, is that by limiting portfolio risk through diversification, you could potentially be mitigating performance in the short term.
Types of investment
Most fund managers and advisers diversify investments across asset classes and determine what percentage of the portfolio to allocate to each. Such asset classes include:
Stocks – shares or equity in a publicly traded company.
Fixed-interest securities – also known as bonds, fixed-interest securities represent a loan made by an investor or a borrower and are often used by companies, states and sovereign governments to finance various projects.
Real estate – buildings, land, natural resources, agriculture, livestock and water or mineral deposits.
Commodities – basic goods necessary for the production of other products or services.
Cash and short-term cash equivalents – savings, cash ISAs, savings bonds and premium bonds.
How do you make the most of it?
The unfortunate nature of investment is that all winning streaks end. It’s human nature to be drawn to winners and avoid losers. But investing is much more fluid, with no particular investment reigning as champion for long. By investing only in what’s doing well currently, you might miss out on any rising stars beginning their ascent to success. You may want to jump from top performer to top performer, however more often than not, the best gains will have been and gone by the time you invest. You may even be investing prior to the asset reducing in return.
In an ideal world, you’d get high returns from your savings and investments with no risk. However, reality dictates that there must be a trade-off – high risk often leads to higher returns.
Though it is sensible to hold part of your assets in low-risk investments, such as Cash ISAs, some see value in investigating more high risk investments in order to acquire those lucrative higher returns. However, you need to make sure that you’d be happy with running the risk of making a loss.
A general rule of thumb is that the older you are, the less you’ll want to expose your investments to market risk – meaning that diversifying into more low risk investments may be the ideal approach for you in order to keep your investments secure.
There are also many ways to diversify within a single kind of investment. For example, with shares, you can spread your investments between large and small companies, UK and overseas markets and within different sectors like technology, financials or raw materials.
Finally, remember that the value of investments, and the income from them, may fall or rise and you might get back less than you invested. Always proceed with caution – diversification helps mitigate the risks but won’t remove them entirely.