Diversification is an investment technique that reduces risk by spreading your assets across different sectors, geographical regions and instruments, among other classifications. You look for a balance of acceptable risk and maximum returns. Ideally, possible losses in one area should be covered by potential gains in another. If you have an investment that could lose value as a result of a particular real-world event, then you should consider investing in a different asset that the same event will likely cause to rise in value.
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The golden rule
Diversification is considered the golden rule of portfolio management. Although risk can never be completely eliminated, diversity of asset class is the best way to achieve long-term growth while keeping risk at an acceptable level.
Diversification reduces what is known as unsystematic risk. This is specific to a particular market, nation, industry or company. However, there is also systemic or market risk that is unavoidable as it goes with the territory of investing. This is caused by factors such as inflation, interest rates and exchange rates that are necessary elements of how the markets work. Outside events that affect every industry and company in a negative fashion may also be considered systemic risks.
Put simply, if there’s no chance of an asset losing value, then there’s no chance of it gaining value either. There’s little point in investing mainly in assets that are completely stable, except as a safety net. Some assets that are unlikely to change in value much one way or another may be brought in as a valid part of a balanced portfolio.
Long-term investment
Diversifying your portfolio, while necessary, can be a complicated and expensive process. There are certainly downsides, especially for the novice investor attempting to go it alone. Diversification is best suited to long-term investment, as the reduced risk levels could also reduce short-term profits. For those looking to increase their wealth over the long run, however, a balanced and diverse portfolio is essential.
Because some asset classes are not designed for the beginner, and multiple investments can be cumbersome and hard to keep track of, it’s recommended to work with a reputable investment services company such as Capital Markets Elite Group that can give you access to major markets and multi-asset investments, as well as extensive market intelligence and expert advice.
Taking advantage of asset management services means that experienced advisors and portfolio managers can help you to develop a customized investment strategy that matches your risk tolerance and long-term goals. You can also design and manage your own portfolio with the dedicated technical support of an in-house team if you want to be more self-directed.
A broad basket
The old saying that you shouldn’t put all your eggs in one basket is the principle behind diversification. If you have a portfolio that consists of shares in one industry, then your profits and losses are completely dependent on the fortunes of that industry. When business is good, you make money, but when business slumps, you lose money.
While individual companies within a sector may struggle or thrive in relation to their competitors for a number of reasons, there may also be outside events that affect the industry as a whole. These may include major shifts in consumer behavior, industrial action, government intervention, global recession, and disasters such as wars or pandemics.
However, in any of these cases, while some industries will be adversely affected, others will prosper. Think of munitions factories in times of war or the manufacturers of cheap household staples during a recession. Investing in these sectors would compensate for unavoidable losses incurred due to your normally profitable investments in, for instance, luxury goods or commercial airlines.
Not just stocks
It’s also important to have different classes of asset, not just stocks and shares. Consider government and commercial bonds, real estate, precious metals and currencies. Cryptocurrencies such as bitcoin are now also considered to be legitimate entries in a well-balanced portfolio. Situating your assets in different countries around the world leaves you less vulnerable to local or national events such as economic downturns and political crises.
How far should you go?
The question of how far you should go in adding different assets is a difficult one to answer. Clearly, diversification can only reduce risk up to a certain point. Beyond that, adding more diverse assets won’t improve your portfolio and may just muddy the waters, so to speak. Where that point is, however, depends on the individual portfolio, your long-term goals, your risk tolerance, and many other factors. This is one reason why it is recommended to get professional advice.
Effective diversification is an art and there is no exact formula for how it should be done. It’s a good idea to rebalance your portfolio regularly, perhaps selling off assets that no longer serve you effectively or adding new ones that will improve the overall mix. At the end of the day, there is no substitute for experience when it comes to optimizing a portfolio, and this is one quality that’s well worth investing in.