What is investment diversification?

What is investment diversification?

Diversification, when applied to investing, refers to a strategy to manage risk within your portfolio. 

Put simply, it involves putting your money into investments across various asset classes, geographical locations, companies, and sectors. This risk-reducing method avoids putting all your money into a single holding, where the chances of losing it all might be higher.

Why is diversification important?

When you put your entire investment into a single company, or even one particular industry, you run the risk of significant losses if anything goes wrong.

For example, let’s say you put all your money into shares with a car manufacturer. Then, perhaps fuel costs rise sharply and geographical conflicts occur, leading to reduced consumer demand and challenges in obtaining parts for production. These problems could result in your shares falling in value.

However, if your money was spread across the car manufacturer and a bicycle manufacturer, it could be a different outcome. The bicycle manufacturer would not be negatively impacted by the fuel cost and production challenges.

Shares with the bicycle company could even grow in value as demand for bikes increases while cars are less accessible, and lead to better returns for you.

Diversification is a good idea to consider, as it’s likely that some of your investments will be successful to counteract any losses in other areas of your portfolio. With various investments, returns come from different industries, at different rates, and over different periods of time.

How to split an investment portfolio

Diversification is about generating smooth, long-term returns by reducing volatility, and is not about maximising short-term returns. 

It can be tempting to invest in the most successful companies to maximise returns. But, by tactically mixing your investment types across industries and locations, you can lessen the blow of any losses with the successes of those which perform better over time.

There is no ‘perfect’ recipe for splitting your money across investments, as this will come down to your personal preferences and goals. In general, a diverse portfolio might include a range of asset types or classes across a variety of locations, sectors, and industries.

Across asset types

When it comes to asset types, there are four main components which contribute to a diversified portfolio:

• Equity funds are invested across a range of shares and are very simple to look after as they are typically managed by a fund manager.
• Bonds are issued by companies or governments to financial markets. Investors essentially ‘lend’ money for a set period of time, and earn interest until the end of the period where you get the initial value back.
• Cash savings involve putting money into a savings account that offers the best interest rates, and watching your savings grow. Interest rates can rise and fall, so the rate of growth can vary, but your money is protected.
• Property ownership offers a steady, long-term income stream, though can require a hefty initial investment, and hands-on management and maintenance.

Some asset types are diverse in nature, and automatically spread your money across different investments. Equity funds mentioned above are an example of a collective investment, with other types of funds following a similar logic. 

Exchange-traded funds (ETFs) and index tracker funds offer investors low-cost exposure to a major market index or a particular market segment. Funds and trusts which are more actively managed, such as investment trusts have the added benefit of professional managerial stock-picking expertise.

Across different sectors and industries

Focusing on just one sector or industry exposes your investment to damage from the fallout of challenges that occur within that sector. For example:

• Legislative changes, such as government policies and new regulations.
• Natural events, such as the pandemic.
• Economic crashes, such as recessions.

The COVID-19 pandemic is a prime example of the benefits of sector diversification. While the travel industry struggled during movement restrictions, online streaming and delivery services thrived. If someone had investments in travel and online services at this time, the losses of the former would be counterbalanced by the gains from investments in the latter.

Across various locations

Investing across different geographical areas reduces the impact of risk attached to any single country. Political, economic and geographic factors can affect any country, such as:

• Change of political party.
• Military coup.
• Currency inflation.
• Natural events, including floods and hurricanes.
• Monetary policy changes that impact the business world.

While international investing has its risks, there are plenty of advantages to consider. Other countries have natural resources or industrial strengths that are not offered by your home market, such as the US technology sector which outperformed other investments over a number of years. High-risk investors can also benefit from evolving domestic markets as nations become more urban and middle class, such as the growth seen in India and Vietnam.

How to manage a diversified portfolio

Diversification is an ongoing job, and it makes sense to review your portfolio regularly. 

Over time, your best-performing assets may start to account for a larger slice of your overall investment pie while the others shrink as values fall. This means your portfolio could unintentionally become less diversified and more risky, opening you up to bigger hits if those large holdings fall.

The reverse could also happen when markets fall, and lead to a portfolio which no longer matches your risk appetite or aligns with your long-term goals and circumstances.

Aim to review your portfolio at least annually or more regularly depending on the investment types in it. Avoid checking too often as you may end up over-trading. It’s important to allow holdings time to prove themselves, which will also save money on trading fees.

Another option for investment diversification is opting for a managed account, such as the ii Managed ISA. Before getting started, you need to determine your personal risk appetite and figure out your goals. Once these key questions are answered, you hand over the day-to-day management to us and we’ll take care of the rest. All you have to do is check in every so often and reap the rewards of your investments.