If you’re thinking about investing money, the chances are that you’ll have encountered the term “diversification” but might not know exactly what it means or why it’s important. Why does diversification reduce risk?

While diversification may sound like a fund manager’s buzzword, it’s actually a crucial investment technique that aims to minimise the impact of financial risk on your invested capital.

By investing in a variety of different assets, you’re diluting – or diversifying – the risk associated with investments. Different kinds of asset tend to behave in different ways; if particular economic conditions lead to some performing badly, others may well fare better.

How does diversification of investments reduce risk?

Well-diversified portfolios are more robust

The old saying “don’t put all of your eggs in one basket” certainly rings true in the financial arena. Investing in stocks alone, for instance, makes you more vulnerable to the effects of risk. This is because the value of your investments depends on the performance of just one kind of asset.

What’s more, by concentrating on a single asset class or narrow range of classes, you could be missing out on lucrative investment opportunities elsewhere.

Diversification involves creating a balanced investment portfolio that covers a range of different kinds of asset and is relatively robust as a result. Broadly speaking, a well-diversified portfolio is stronger than a portfolio that’s focused on one particular area of investment.

“Diversification involves creating a balanced investment portfolio that covers a range of different kinds of asset and is relatively robust as a result.”

With a broad range of investments, you’ll be in a better position to cope with market fluctuations than if you direct your financial resources towards a small number of asset classes. As a result, you should benefit from more stable returns in the long run.

Of course, diversification isn’t a cast-iron guarantee that you won’t suffer losses. Markets and investments will always be, to some extent, changeable and unpredictable. However, a diverse portfolio helps you to limit the damage, boosting your chances of reaching your financial goals. You can’t eliminate risk, but you can reduce it. In fact, you can think of diversification as a means of cushioning your money against economic shockwaves.

Why does diversification reduce risk: our advice

When investing, it pays to be sensible. The following approaches can help you to build a well-diversified portfolio.

• Investing in a variety of asset classes (e.g. bonds, property, stocks, etc.)
• Invest in more than one country or region
• Choose a range of industries and companies

Another tip is to avoid restricting your investments to asset classes that exhibit a high level of correlation (i.e. those that respond to market forces in very similar ways). If your investments go up or down together, you can’t reap the benefits of diversification.

How diverse should your portfolio be?

There are a few key points to consider when you’re trying to achieve the most appropriate level of diversification for your needs.

Risk tolerance

Some types of asset are riskier than others. For example, stocks tend to be more volatile than bonds but have more potential for growth. You need to decide whether or not you’re comfortable with the idea of including high-risk investments in your portfolio.

“Broadly speaking, a well-diversified portfolio is stronger than a portfolio that’s focused on one particular area of investment.”

The bigger your appetite for risk, the more likely it is that you’ll experience extreme highs and lows. If you’re a cautious investor, you might want to invest solely in low-risk assets, even though the returns are likely to be low too. More diversified portfolios include a range of risk levels, without being heavily weighted towards high-risk assets.

Investment timeframe

Including a diverse range of assets and risk levels in your portfolio can be ideal if you’re committed to being a long-term investor, as there’ll be plenty of time for the value of your more high-risk investments to recover from periods of extreme volatility. Are you an investment tortoise?

If you want to access your money soon, a less diversified portfolio is best.

Amount of capital

If you over-diversify your investments, you’ll spread your capital too thinly – and may find that the fund management costs are too high to make investing worthwhile. This is a particularly important consideration for investors with small amounts of capital.

Download our free guide to investment diversification

As a boutique Chartered Financial Planning firm, we have the expertise to help you make sound investment decisions. We help our clients to navigate the complex world of investment and achieve their financial objectives.

As a first step on the road to building a balanced investment portfolio, why not download our helpful free guide to investment diversification?

Why does diversification reduce risk? – find out more