Why diversification is an important part of your portfolio

01 Sep 2021

Diversification is a term often thrown around when people are talking about investment strategy. The most straightforward explanation is it’s spreading your assets out over several investments rather than having all your eggs in one basket. There are a few reasons why this may be a good idea for you and different factors you have to consider.

Diversification helps reduce risk

Having all your funds in a single investment can be a recipe for a stressful existence. When things are on the up you won’t have a care in the world. However, most investments will fluctuate up and down over time. As Frank Sinatra sang, you’ll be riding high in April, shot down in May.

By spreading your investments across different assets, you aim to have losses in one area offset by gains in another. The theory is that broad diversification should smooth out your returns and keep you on a steady growth path. All investments can carry a risk. Diversifying your portfolio won’t eliminate risk entirely. It will reduce your risk by reducing your exposure to the fluctuations of a particular investment.

You need at least three different asset classes

The main idea here is to reduce risk by having different investments in your portfolio counteract each other. To do this, you will need exposure to varied asset classes. Buying shares in different banks is not diversification. If the banking sector has a bad day (type banks and 2008 into Google, for example), you’re still going to suffer significant loss overall.

How you break up your investments will depend on several factors.

  • What level of risk will stop you from sleeping at night?
  • What are your investment goals?
  • How long do you have to reach those goals?

Find the best mix for you

As a general rule, most portfolios should have three different asset classes. You might choose stocks, bonds, and real estate, for example.

Beyond this, however, you can further diversify your portfolio. You can buy stocks in different industries, such as retail and mining companies or tech stocks. Spreading investments between countries, such as the U.K., U.S, and Japan, is another way to spread your risk. This can get hard quickly when making personal investments, so vehicles such as ETFs often come in handy.

Better returns over the long haul

While diversification may limit returns over the short term, smoothing growth often leads to better long-term results. You can’t eliminate risk from investing, but you can reduce it.