The beginner's guide to investment Five-step guide to diversification
One of the principle tenets of spreading risk in your portfolio is to diversify your investments. Diversification is the process of investing in areas that have little or no relation to each other. This is called a low correlation.
You can also invest in assets that have a negative correlation. This means that the assets will move in opposite directions to each other.
Diversifying your assets helps spread risk because you're lessening the potential for losses. If you had all of your money invested in one asset, sector, or region and it began to drop in value, your investments would suffer.
By investing in assets that aren’t related to each other, while one part of your investment portfolio is falling in value, the others aren’t going the same way. Some assets will actually go up in value when others decrease.
You can diversify through investing in different markets, countries, companies and asset type.
Diversification is an essential part of building your investment portfolio. It can give you peace of mind that your investments will sustain in adverse market conditions and cushion losses. But it will not lessen all types of risk.
Diversification helps lessen what’s known as unsystematic risk, like drops in the value of certain investment sectors, regions or asset types in general. But there are some events and risks that diversification cannot help with, or systemic risks. These include interest rates, inflation, wars and recession. This is important to remember when building your portfolio.
Here are the five main ways you can diversify your portfolio:
Step 1: Assets
Having a mix off different asset types will spread risk because their movements are either unrelated or inversely related to each other. It’s the old adage of not putting all your eggs in one basket.
Probably the best example of this is shares, or equities, and bonds. Equities are riskier than bonds, and can provide growth in your portfolio, but, traditionally, when the value of shares begins to fall bonds begin to rise, and vice versa.
Therefore, if you mix your portfolio between equities and bonds, you're spreading the risk as when one drops the other will rise to cushion your losses. Other asset types, like property and commodities, move independently of each other and investment in these areas can spread further.
Step 2: Sector
Say you held shares in a UK bank in 2006. This investment may have been very rewarding, so you decide to buy more shares in other banks. When the credit crunch hit the following year sparking the banking crisis, the value of your shares in this sector (financials) would have tumbled.
Once you've decided on the assets you want in your portfolio, you can diversify further by investing in different sectors, preferably those that aren’t related to each other.
If the healthcare sector takes a downturn, this will not necessarily have an impact on the precious metals sector. This helps to make sure your portfolio is protected from dips in certain industries.
Step 3: Geography
Investing in different regions and countries can reduce the impact of stock market movements. This means you're not just affected by the economic conditions of one country and one government’s fiscal policies.
Many markets are not correlated with each other - if the Asian Pacific stock markets perform poorly, it doesn’t necessarily mean that the UK’s market will be negatively affected. By investing in different regions and areas, you're spreading the risk that comes from the markets.
However, you need to be aware that diversifying in different geographical regions can add extra risk to your investment.
Developed markets like the UK and US are not as volatile as some of those in the Far East, Middle East or Africa. Investing abroad can help you diversify, but you need to be comfortable with the levels of risk that come with them.
Step 4: Company
Don’t just invest in one company. It might hit bad times or even go bust. Spread your investments across a range of different companies.
The same can be said for bonds and property. One of the best ways to do this is via a collective investment scheme. They will invest in a basket of different shares, bonds, properties or currencies to spread risk around. In the case of equities, this might 40 to 60 shares in one country, stock market or sector.
With a bond fund, you might be invested in 200 different bonds. This will be much more cost effective than recreating it on your own and help diversify your portfolio.
Step 5: Beware of over diversification
Holding too many assets might be more detrimental to your portfolio than good. If you over diversify, you might not end up losing much money, but you may be holding back your capacity for growth as you’ll have such small proportions of your money in different investments to see much in the way of positive results.
It’s usually recommended that you hold up to 15-20 investments (be it shares, bonds or funds) as a maximum.
For more on investing, also see our book Save and Invest.