What is diversification?
Diversifying your investment portfolio is the process of spreading out your investments into different types of investments. It essentially means you’re not putting all your eggs in one basket.
A poorly diversified investment portfolio might only hold cryptocurrencies for instance, or worse, only hold Bitcoin. On the other hand, a highly diversified portfolio would include different stocks from different industries, different asset classes and investments in different areas of the world.
Why should you have a diversified portfolio?
In short, a diversified investment portfolio reduces risk. A portfolio that only contains similar types of assets would be at risk of being hit hard by one piece of news or event whereas a portfolio consisting of different types of investments is better protected against this.
Consider a portfolio that only consisted of stocks and shares in the travel industry just before the pandemic hit. As the travel industry shut down due to lockdowns, stock prices fell which would’ve resulted in the whole travel-focused portfolio being plunged into the red.
Now consider the same portfolio at the same time but with some tech-focused stock investments added. Yes, your travel-related investments would still be down due to the pandemic but your losses would’ve been reduced, possibly even eliminated, by your rising tech stocks as people turned to technology to aid their switch to working from home.
Ways to diversify your portfolio
Company/sector/industry diversification
The travel vs tech example above shows how diversifying your stock market investments across different industries can hedge against negative industry news. News that is negative to one industry is often positive to another, as was the case with the news of the COVID pandemic.
As airlines found their fleet grounded and hotels were lacking tourists, the likes of Netflix and Microsoft benefited from families swapping holidays for indoor home entertainment.
Diversifying your investments across competing industries and sectors is one way to diversify, but diversifying between competing companies within the same sector can also be a smart way to spread out your portfolio. For example, if Tesla was to be hit by a controversial scandal, other EV stocks would likely rise making it worthwhile to have interests in competing companies.
Index funds
An index fund tracks the performance of a whole market as opposed to the performance of individual stocks. Investing in an index fund has many benefits to investors including not having to hand pick a basket of individual stocks that they think will perform well.
Perhaps the biggest benefit to investors though, is how easy it is to diversify your investments. An S&P 500 index fund for example, would track the performance the S&P 500 index, made up of the 500 biggest US companies listed on the stock exchange.
As the US’s biggest companies are spread across different sectors and industries, anyone investing in an S&P 500 index fund is automatically diversifying their portfolio.
Asset types
The infamous Wall Street crash in 1929 resulted in massive losses across the board. Anyone who only invested in the US stock market at this time would’ve likely been hit hard. Similarly today, a lot of younger investors target cryptocurrencies and open themselves up to the same risk if they choose to completely neglect more traditional asset types.
Investing in different types of assets is the best way to safeguard against sudden market crashes or corrections. If an investor holds investments in the form of stocks, cryptocurrencies, real estate, metal and collectables, any crash shouldn’t hit quite as hard.
In today’s digital world, it’s easier than ever to spread your investments across different asset types. Platforms like eToro allow users to invest in real estate ETFs while crypto exchanges like Binance allow users to trade cryptocurrencies. It’s worth noting that with increased opportunities comes increased dangers. Binance fraud and other types of crypto scams need to be protected against and anyone looking to invest in more modern asset types should educate themselves about common scams.
Geographical
Spreading your investments across the world is a good way to protect yourself against poor investment performance in one particular country or continent. A good recent example of this is how the Russian stock market tanked shortly after the invasion of Ukraine largely due to sanctions imposed from other countries not wishing to do business with Russia. As a result, anyone who only invested in Russian stocks around this time would’ve seen their portfolio value plummet.
Ironically, Russia has long made up part of the ‘BRICS’ acronym attributed to five nations considered some of the most emerging countries in the world. The full BRICS acronym stands for Brazil, Russia, India, China, and South Africa.
Many investors have tried to capitalise on the emergence of these nations to protect themselves against the poor performance of their domestic investments.
Summary
Investing can be very complicated and is something that many people avoid because of its complexity. However, this shouldn’t mean that you avoid it as there are many financial services which can cover investing for you. If you decide to invest yourself then you should ensure you diversify your portfolio to help generate more wealth and safely
