Investing can seem like it’s filled with jargon that’s difficult to get your head around. “Diversification” is one such common term you may have come across. Read on to find out what it means and why it’s important for your investment portfolio.
In simple terms, diversification means spreading your investments across a variety of opportunities.
As all investments carry some form of risk, the key reason for diversifying is so the risk you’re taking is spread out and there’s less chance of the value of your investment portfolio falling.
You can think of diversifying like building a well-balanced meal. While they might be good for you, a plate of green beans isn’t going to be healthy in the long run or very satisfying. Instead, you might want to add protein, dairy, carbohydrates, and other types of vegetables to create balance.
So, while investing in a single company might be a good opportunity on its own, when you look at your wider strategy it’s often a good idea to add other elements by diversifying.
How diversification works in practice
So, now you know what diversification means, but how does it work in practice? The Financial Conduct Authority explains how diversification works with three scenarios.
1. No diversification
With this option, you’d invest all your money into one company’s shares. You might come to this decision based on some research you’ve done or a tip someone has given you.
Your investment performance completely relies on how that one company has performed. So, it could go very well – or very badly.
As a company’s shares change significantly in price depending on a range of factors, such as sales performance or how legislation may affect operations, you might experience large swings and volatility. There would be a greater risk of losing some or even all of your money.
2. Some diversification
If you consider diversification to some extent, you might invest in a range of UK companies. This way, your investment performance isn’t tied to a single company. Instead, the risk is spread across a group of companies.
Ideally, you’d invest in companies that operate in different sectors. So, if one sector experiences struggles, the gains in another could balance it out.
While this option provides more stability than the first, there could still be factors that affect a large portion of your portfolio. For instance, as all the companies are based in the UK, an economic downturn is likely to affect many of your holdings.
3. Full diversification
Finally, if your portfolio is fully diversified, you’d invest in a range of assets and markets.
So, you’d continue to invest in UK companies by purchasing shares, but you might also hold some of your money in cash or invest in bonds. In addition, you might invest in markets outside of the UK, such as Europe and the US, or even further afield in developing markets.
This approach means your investment portfolio is spread across several different types of investments. You’re not putting all your eggs in one basket and the long-term performance is likely to be smoother as a result.
Investment funds could provide a way to ensure your portfolio is diversified
Managing a diversified portfolio can be time-consuming and complex – it’s likely to mean a lot of initial and ongoing research into different companies, economies, and markets.
So, funds can provide a way for the average investor to diversify their portfolio.
A fund would pool your money with that of other investors and invest it in a range of assets that meet its criteria. This way, investment risk is spread across different sectors and geographical regions without you needing to make decisions about each individual investment.
There is a huge range of funds to choose from, including various risk profiles. Understanding what level of risk is appropriate for your goals or circumstances is crucial, whether you choose to invest in a fund or buy individual company shares.
As part of your financial plan, we can help you understand what level of risk might be right for you.
Contact us to talk about creating a diversified investment portfolio
An investment strategy that includes diversification can manage risk and make your investment performance smoother. If you’d like to talk about your investment portfolio and how to ensure it meets your needs, please get in touch.
Please note:
This blog is for general information only and does not constitute financial advice, which should be based on your individual circumstances. The information is aimed at retail clients only.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
Investments should be considered over the longer term and should fit in with your overall attitude to risk and financial circumstances.