When you invest your finances, you should always have an investment planning strategy behind your decision-making process. One of the most common ways to mitigate risk and build a balanced portfolio is by utilising a diversified portfolio.
As with any investment method, the advantages and disadvantages of diversification should be considered before adopting this type of portfolio. In this blog, we’ll be exploring the meaning of diversification in investing, why it’s important, as well as the benefits and downfalls of this strategy.
What is diversification of investments?
The diversification of investments is a strategy that aims to mitigate risks and encourage stable returns by creating a varied portfolio. In essence, a diversified portfolio can limit your exposure to volatile market behaviours by spreading out investments across varying asset classes and sectors.
For example, a diversified portfolio may include a mix of stocks, bonds, and private equity. However, you can diversify your investments across a wide range of factors, including asset classes, companies, industries, and even global investments.
Importance of diversification
As an investment strategy, diversification is important because it can help improve the performance of your portfolio by reducing the amount of risk your capital is exposed to. When you incorporate a multitude of stocks, share classes and investment types into your investment fund, you may reduce the likelihood of large monetary losses.
Although your returns or losses are still subject to stock market fluctuations, a single negative event is unlikely to crash all your holdings. For example, if you hold stock in American, Chinese, and British companies, and the US economy experiences a downturn, the other international assets may be unlikely to be affected.
Advantages of diversification
Reduces risks and increases the chance of reward
One of the main benefits of diversification is the mitigation of risk in your portfolio.
Although there is no guarantee that diversified investments will yield higher results, you can smoothen out average losses in volatile markets and minimise the impact these may have on your overall portfolio.
If the value of one stock falls, you can still rely on your other investments to lessen the burden.
Diversification strategy aligns with your financial goals
When you invest across several varying sectors and assets, you can allocate investment by financial goals.
For example, let’s say you are saving up for a long-term financial goal, such as your retirement fund, you may choose to invest in high-risk markets initially but reduce your risk level as retirement approaches to reduce the potential impact of losses on your final pension pot.
You may have additional, intermediate-term financial goals, such as paying off your car loan. In this instance, you could invest in assets with higher risks and fixed income characteristics.
Exposes you to various financial growth opportunities
Investing in numerous types of asset classes exposes you to various financial opportunities, rather than solely focusing your efforts on one segment of the market.
You can take greater advantage of movements and trends in the market by spreading out your investments across a wider range of assets.
For example, you could yield results from various geographical regions or a diverse range of industries rather than having to choose between one or the other.
Disadvantages of diversification
Portfolio may be left unmanaged and unreviewed
One of the main disadvantages of diversification occurs when the portfolio is left unmanaged or unreviewed.
Under these circumstances, the mix of your assets could become unbalanced, and the nature of some investments may change, for example, they could become riskier over time or unethical.
Potential to make investment mistakes
When you strive toward a completely diversified portfolio, you may focus all your efforts on selecting the correct investments and, in turn, run the risk of selecting the wrong ones.
This poor decision-making process could dilute your potential returns. However, this is not always one of the disadvantages of diversification but a general downfall of investing as a whole. In this instance, seeking expert guidance can be beneficial, as financial advisors can help you make more informed decisions and monitor the performance of your assets.
Tax implications and cost of investment
You’ll need to be wary of the appropriate tax regulations each type of investment incurs. Although using a tax planner may come with a cost, they can advise you on certain tax implications that may save you from making costly mistakes.
Similarly, each type of asset may have different fees and charges, so you’ll need to factor these in too.
FAQs
What is risk diversification?
Risk diversification is an investment strategy that focuses on balancing risk by creating a portfolio with a wide range of investments across different sectors and assets.
What type of risk does diversification eliminate?
Although diversification does not eliminate risk in its entirety, it helps smooth the returns and average the potential highs and lows within your investment portfolio.
Why does diversification reduce risk?
A diversification strategy can reduce the level of risk by spreading out investments across a variety of industries, assets, and markets. Since your capital is invested across separate categories, your potential returns or losses will react differently to individual events.
Final thoughts
Putting all of your eggs in one basket, for example one asset-class, could mean that all of your hard-earned money can be wiped out in one fell swoop.
By electing to employ a diversified strategy you may still experience losses on some of your assets, but you could also see gains in other areas, hence your overall performance will be smoothed over time and the impact of losses is greatly reduced.
However, it’s crucial to keep your investments continually under review, so that suitable adjustments can be made as required.
If you still need advice regarding diversification growth, Efficient Portfolio works with a wealth of professionals who will be able to guide you further on the matter. Contact us today.
