What is diversification?
In practical terms, diversification is holding investments which can react differently to the same market or economic event. You may have previously been warned about putting all your eggs in one basket and that it is prudent to spread your investments across a range of assets. That way, if the value of one of them falls, it could be mitigated by your other investments that increase. This is a basic strategy of mitigating risk whilst potentially having a limited overall effect on your returns.
How to diversify your investments
The best way to achieve this is to invest in different asset classes across various countries, regions and industries. The main asset classes in most portfolios consist of shares and bonds as these tend to behave differently. When you invest in shares, you buy into a company’s ongoing operations and profitability. The value of shares fluctuate according to the fortunes of the company, so they are riskier than bonds. However, with greater risk comes greater potential reward and so the returns can be greater too. A bond is effectively a loan to the issuer in return for a fixed interest payment. For example, a UK government bond, known as a gilt, is considered to be among the least risky investment, as the UK government is unlikely to default and so returns can be lower.
Most portfolios will also diversify holdings across developed countries e.g. the UK, the US, Europe and also the far-east and the emerging markets (EMs). Developed countries typically have relatively stable economies and stock markets comprising large, well-established companies. EMs on the other hand, are growing faster so they offer greater potential rewards, however, they tend to be more unpredictable so they are regarded as higher risk.
How diversification actually works
During times of uncertainty, bonds can rally as investors move their money out of shares and into safe-haven assets such as gold. When the outlook improves, shares rebound as investors switch back to taking greater risk in return for what they hope will be a higher reward.
As for geographical diversification, any number of economic or political factors can weigh in on the financial markets in one country or region without necessarily spreading into others, however, there are often exceptions.
While individual asset classes can suffer severe declines, it's very rare that any two or three assets with very different sources of risk and return, like shares, government bonds and gold, would experience declines at the same time. So even if shares took a sharp correction of say 30%, your bonds and gold could keep your portfolio from falling as far. This is why diversification is important in your investments.
The benefits of diversification include:
• minimises the risk of loss to your overall portfolio
• exposes you to more opportunities for investment return
• can safeguard you against adverse market cycles
• reduces volatility.
How to tell if you are diversified
An easy way to determine if your portfolio is diversified is by looking at your current and past performance. Diversified investments will not move in the same direction at the same time. So, if some of your investments are up while others are down, diversification exists
A good way to think of diversification is having 'ice cream and umbrellas' and you will fare better in all weather.