When investing, it is crucial to make sure you manage the risks associated with your investment in order to protect your investment from unexpected market changes.
While there are a number of strategies, you can adopt to protect your investment, one of the critical elements every portfolio needs is diversification.
So, what does diversification bring to your investment portfolio?
Diversification
Diversification is a tactic used by most financial planners and fund managers. It is an investment management strategy that blends different asset investments across a number of industry or sectors in a single investment portfolio. Diversification is one of the most common investment management strategies and is brought in for two distinct reasons:
- A variety or range of investment options can yield a higher return in investment.
- A diversified investment portfolio should reduce the level of risk they are exposed through investing in several different sectors and asset types.
Risk
One of the most essential elements of any investment strategy is the level of risk you can expose yourself to.
A select grouping of factors determines the level of risk you can be exposed to. These include, how much you want to invest, the sector you want to invest in, your investment strategy, the timescale for returns and most importantly, the capital you have to support your investment.
Understanding your level of risk is an important component to consider when investing. Not only will it provide you with a picture of the potential losses you can manageably accept (swings in the value of your investment), it provides a basic image of what you can afford in the long-term.
For those who are unsure what risk means for your investment – the greater the risk, the greater the chance of receiving higher returns. While lower-risk will naturally mean your growth or returns may take longer to materialise.
So how can you diversify your investment options?
There is no golden formula to diversifying your investment portfolio. As investment strategies differ from fund to fund, the best way to diversify your investment portfolio will naturally change from person to person. However, there are a number of common elements which can be utilised:
1. Choose a range of assets
One of the most successful ways to minimise risk while ensuring high potential returns is to spread your investment across a number of varying asset options. Although certain asset types provide investors with fast and relatively reliable returns, having a collection of different assets will help you spread the level of risk across a larger area.
The theory behind this approach is simple. Each asset value can move in different ways due to market trends and often for a number of external and internal factors. Due to the nature of the stock market stocks will naturally react to strong or weak performance of a company or external influence from other investment trusts trying to short the price. Bonds are influenced by interest rates – having a range of assets in your portfolio could not only help you see healthy returns, but it also protects you against a potentially significant downturn in a single asset class.
2. Diversify by sector or industry
Diversifying by sector or industry is the natural step from choosing a range of assets. While investing in a variety of assets will decrease the level of risk associated with an investment portfolio, this can be aided by diversifying the sectors or industry you are investing in.
Different markets and sectors are not always correlated or related to each other. Once you have chosen the assets you want to include in your portfolio, you can pursue these across a number of different industries to ensure you are protected if external factors influence a particular sector. Examples of a diverse portfolio by sector can include, manufacturing, air travel, hospitality and insurance.
The theory behind this investment strategy is simple. If you invest in several sectors which are not related, if one experiences a downfall, a non-related sector should not be impacted and therefore continue to grow in value.
3. Diversify through location
Investing in overseas is an excellent way to increase your returns at relatively low risk. While it is widely common practice to spread your investments across sectors, investors typically limit themselves to local markets. For those looking for new more extensive investment options, international companies or markets, with Chinese giants, European conglomerates and far-east investment potentials, all provide investors with a niche way to diversify their investment portfolio.
4. Buy shares in a lot of companies
Now you have chosen your asset class and the industry you want to invest in, it is recommended you invest in a number of companies instead of placing all your eggs in one basket.
If you buy shares in a single company and they experience bad times/ go bust, your investment will still be at risk even if you diversified across several industries. If you invest shares in a multitude of companies, your investment will be far safer if this happens.
