Diversification is a word that you hear 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.
By smoothing out the risk of each investment within your portfolio, you are 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.
Most fund managers and advisers diversify investments across different asset classes and determine what percentage of the portfolio to allocate to each, as part of their service.
The unfortunate nature of investment is that all winning streaks end. It is 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 is 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 would get high returns from your savings and investments with no risk. However, reality dictates that there must be a trade-off – although higher risk can often lead to higher returns it can also potentially lead to greater losses.
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 will not remove them entirely.
5 June 2019
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