Diversification is a word that tends to get mentioned 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 blends a variety of investments within a portfolio. Through having different kinds of assets in a portfolio, the aim is to achieve 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 counteract the negative performance of some investments with the positive performance of others. While your portfolio will only benefit when the different assets are not perfectly correlated, you want them to respond differently to market and economic factors.
One downside to be aware of, though, is that by reducing portfolio risk through diversification, you could potentially take the edge off performance.
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:
• Cash and short-term cash equivalents – cash, deposits and money-market instruments.
• Fixed-interest securities – also known as bonds, fixed-interest securities represent a loan made by an investor and are typically used by companies, states and sovereign governments to finance various projects.
• Property – commercial property makes up a large part of the property sector. It’s broadly divided into three areas: industrial, retail and office.
• Stocks – shares or equity in a company.
• Commodities – basic goods necessary for the production of other products or services.
How can you make the most out of diversification?
The unfortunate nature of investment is that all winning streaks come to an end. It’s human nature to be drawn to winners and avoid losers. But investing is much more fluid, with no specific investment leading the pack for long. By investing only in what’s doing well now, you might miss out on any rising stars beginning their ascent to the top. You might want to jump from best performer to best performer, however more often than not, the biggest 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 zero risk. However, reality dictates that there must be a trade-off— high risk often leads to higher returns.
While it is sensible to hold part of your assets in low-risk investments, such as Cash Individual Savings Accounts (ISAs), some see value in investigating more high risk investments in order to obtain those potentially 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 capital to market risk—meaning that diversifying into lower 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 asset class. 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. Past performance is not a reliable indicator of future performance. Always proceed with caution—diversification helps mitigate the risks but won’t remove them entirely.
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