As any investor will tell you, investing can be a rollercoaster.
Not all investments behave in the same way – different types of investments behave differently under certain economic and market conditions. Some may go up while others go down. Some may be entirely negatively correlated.
This is where diversification comes in. Essentially, diversification means investing across a range of different investment types that behave differently across a full investment market cycle. While nothing will give you an absolute guarantee against loss, spreading your investments across different investment categories and types of assets limits your exposure to individual related risks.
Risks can be in the form of market risks, where the market may become less valuable for assets within a particular class due to external factors, like interest rate changes, war, or weather events. Or, they can be asset-specific risks, which come from the performance of investments or companies themselves, often dependent on management’s performance, operational activities or competitor actions, for example.
There are all sorts of ways to diversify your portfolio to mitigate these risks. Diversification can occur across asset classes (e.g. equities, property, cash), industries (e.g. telecommunications, agriculture, financial services), or regions (e.g. countries, markets, economies).
Diversifying by asset class
Different asset classes - like real estate, equities and bonds - generally behave differently under similar economic conditions. For example, if a market crash sends the stocks in your portfolio tumbling, the assets in other uncorrelated asset classes may not lose value at the same rate, or they may move in the opposite direction and increase in value, thus providing a stabilising impact.
For example, commodities like gold may not have a correlation to real estate.
Diversifying by industry
Like asset classes, different industries often encounter different risks at different times based on a number of market factors. When one industry encounters a downturn, another might flourish. Diversifying your investments across sectors ensures that your financial wellbeing is not totally dependent on the fate of a single industry.
For example, if you decide to invest all your money into one type of agricultural crop such as wheat, then adverse weather conditions could wipe out the crop rendering your entire investment worthless. But if you had invested across other industries that aren’t impacted by weather, such as healthcare or financial services, only a portion of your savings would be impacted by this weather event.
Diversifying by region
The same applies for regions. The landscapes of countries, markets, and economies are based on unique dynamics, and certain risks may affect some regions rather than others.
For example, one region may be in economic expansion while another is in contraction. Exposure to different currencies, and to different political and regulatory environments can have an impact on an investment.
Having your investment diversified across asset classes, industries and regions is important for investment success, and helps to ensure that your range of investments don’t all perform in the same way at the same time. Therefore, overall investment returns may be achieved in a less volatile way, relative to holding only one or two different assets.
In determining the right asset allocation for your portfolio, you’ll need to consider the overall risk and return of each asset, and how different assets correlate with each other. It’s also important to determine your own risk and return level that you are comfortable with and able to tolerate.
Diversification serves as somewhat of a safety net, capturing the potential benefits of various investments while mitigating the risks associated with market fluctuations.
It’s always important to remember that any decisions you make should be in line with your own financial objectives, as each person’s investment needs will be different.
The content contained in this article represents the opinions of the author/s. The author/s may hold either long or short positions in securities of various companies discussed in the article. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the author/s to express their personal views on investing and for the entertainment of the reader.