If you've started to research the key principles of investing, you are likely to have come across the term portfolio diversification. As rule number one in investing, it is one of the key strategies to understand, so what exactly does the term mean?
It is worth noting that although an investment can rise, it could also fall in value and you may receive less than the original investment amount. Investments in the past which returned a profit can provide no future guarantees to positive results.
Firstly, we should look into what an investment portfolio is. A portfolio is a group of assets which are held by a trading company or individual trader.
An asset can take many forms such as bonds, stocks, commodities or derivatives. These assets are selected by you or the manager of your investment after carefully considered research.
Many investors believe the key to success in the long term is to diversify well, instead of relying on one form of asset. Our Trading Education team believes that the key lies in spreading the risk among high and low-risk investments.
When a particular market takes a tumble, if you have spread the risk you will be better protected against any major losses.
Variety is the key
Many investors make the mistake of believing they have diversified by purchasing shares in a few companies, rather than sticking to one. This is a good idea but true investment diversification is achieved by investing in a wide variety of asset classes. There are four traditional types of asset classes; equities, fixed income, money market and alternative investments such as property and commodities.
Another important factor is geographical diversity. IG reports that an experienced investor will consider trends around the world, rather than sticking to their home market. An emerging market may experience rapid periods of growth in comparison to markets which have already achieved a strong level of development, although this could carry a higher level of risk.
To put this into Online Forex Trading terms you may look at some of the more exotic currency pairs from emerging markets rather than established stable currencies such as the EURO, GBP or USD.
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A term you may hear often is market cap, which is commonly used by companies when referring to their market capitalisation. IG explains the term refers to the total value of all outstanding shares on the market. It is advisable to invest across the whole of the market cap spectrum, from the micro-cap stocks through to the blue-chip mega caps.
By selecting stocks and bonds from a variety of industries and sectors, your investments will carry a higher level of protection against an economic downturn. Choosing sectors which are not affected by levels of consumer spending such as pharmaceuticals or utilities are a great low-risk option.
There are some stocks which fall into the cyclical category because they are heavily exposed to economic cycles. These stocks usually perform well as an economy expands, but during any periods of economic contraction, they carry a heavy risk. The most common examples of these would be retailers and house builders.
Risk management
It is important to remember that diversifying will not completely remove the risks of investing, although it will help you manage the market. If you currently own 10 stocks all from different companies and different industries, there is a high chance that their share prices are not correlated. So, if one share takes a tumble it is unlikely the others will, meaning your overall portfolio will be better protected. IG explains that a single struggling stock only counts for a small percentage of your overall exposure.
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Steady returns
It has been proven by many successful investors that strong levels of diversification will help a portfolio avoid the large changes in the market. By establishing a good level of variety you are likely to own a range of favourable investments, which will balance out any which are taking a hit. Fidelity studied the annual returns of a variety of portfolios over an 89-year period. They found that portfolios with high levels of risk would be too uncomfortable for the majority of investors. For example, the most aggressive portfolio in the study owned 30% international stocks and 70% domestic stocks, which provided an annual return on average of 10%. While this may sound like a steady return, in the best year the return was 163%, but in the worst year it lost 68%. By broadening the asset range, the portfolio was able to reduce the highs and lows, without losing too much over the long term.
A balance between risk and reward
A successful investment will fit with your desired levels of risk tolerance, which will often change throughout your life. It is common for investors approaching retirement to choose conservative assets, as they are likely to have less time to recover from any losses. It is not necessary to overhaul your whole portfolio in one go, effective diversification can be a gradual process. It is better to make informed choices and avoid holding poor assets for the sake of diversification.
We hope you found this article on why you should diversify your portfolio helpful. If you are interested in diversifying your portfolio with an online trading account, make sure you sign up to one of our Free Online Trading Education courses.
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The original article can be found through IG and was written by Hannah Smith.