A diversified portfolio is one where the investments are spread across different geographies, sectors and asset classes in order to reduce overall risk. This is known as diversification and it has been proven to reduce risk cost effectively.
Many investors maintain a diversified portfolio in order to reduce volatility, the short-term ups and downs inherent in stock markets. It doesn't guarantee returns or protect you against losses, but it should help you to achieve more consistent investment returns over the long term.
How diversification works
Think about it this way. You have £10,000 to invest. You decide to invest it in the shares of one company, 'Europabank plc'. But a few months after you buy the shares, the global financial crisis hits, and banking stocks fall heavily. A number of European countries are having their own crisis, so European stockmarkets get hit. Finally, the chief executive of your beloved Europabank resigns in disgrace, and the share price of Europabank tumbles as a result. Before you know it, your £10,000 has been turned into shares worth just a few pounds and pence.
Your mistake? A lack of diversification. Instead of spreading your risk by holding a number of different investments, you took a gamble on a single asset class (equities) and a single company, but you didn't take into account the number of risks associated with that investment:
- Sector risk: As your investment was in a bank, when the banking sector performed badly, so did your stock. If you were invested in additional sectors, such as pharmaceuticals or mining this risk could be reduced.
- Geographic risk: European stock markets fell heavily, which affected your investment. If you were invested in companies in other global regions this risk could be reduced.
- Business risk: The investment you chose suffered as a result of its own internal issues. If you are invested in a broader range of companies, this risk would be reduced.
If you diversify, you stand a better chance of emerging from disasters like this one without losing all your money. Look at this example instead. Say you instead invested £500 each in a mix of 20 different investments, across different asset classes, such as property and bonds as well as equities. And across different countries and different sectors, each with different factors driving their growth. Even if your Europabank shares ended up worthless, there's a good chance that many of the other companies in your portfolio would perform well, and some maybe even well enough to cover the loss of your Europabank investment.
True diversification is no easy feat
Creating a fully diversified portfolio takes considerable time and effort. There are many pitfalls to avoid. For example, many seemingly different stocks and funds are exposed to the same underlying risks and behave similarly despite their apparent differences. And the task isn't complete when you've assembled your portfolio. It's very easy for a well-diversified portfolio to come unbalanced after time, as some investments do better than others. You could find yourself holding too much of one particular asset and not enough of another.
And that's where professional financial advice and investment management could help, ensuring that your portfolio is truly diversified and regularly monitored and rebalanced to match your attitude to risk.
Whether you view diversification as a 'free lunch' or not is up to you. But by diversifying your investments you're acknowledging that although investment markets can be hard to predict, you're not going to let unpredictability dictate your investment returns. With investment diversification, it's fine if some of your assets have a bumpy ride from one year to the next, because you hold enough different investments to deliver a smoother investment journey overall.