By Catherine Thomas-Humphreys, The Finfluencer
In investing terms, diversification is the word that describes the phrase “don’t put all of your eggs in one basket”. But what does that mean and how do we go about it?
When you focus on one investment type, and it fails or falls, you risk losing all your “eggs”.
Using this analogy, you are simply making sure your money (the eggs) is divided between a variety of different kinds of baskets (investment types).
So, diversification is simply a risk management strategy. It is an essential tool when investing to reduce the overall impact of risk. By mixing a wide range of investment types from different companies, countries and industries, you minimise the risk to your investments if things in the economy change.
It’s used to help smooth out the ups and downs your investment portfolio could go through if you hold too few, or too many similar investments. When you don’t diversify, your investments are at a greater risk of loss.
Here’s a simple example
You buy shares in Google only and Google goes bust; you’ve lost everything!
If you diversify into multiple companies and buy shares in Google, Apple and Microsoft, you have diversified by company…but they are all in the same sector, technology. So, if something happens to the technology industry you may lose some or all of your eggs.
If you diversify across companies and sectors and buy shares in Google, Costa Coffee, Johnson & Johnson and British Gas, you now have different companies and different sectors and the likelihood of technology, food, pharmaceutical and utilities all losing money simultaneously is much lower.
You have diversified. You have put your eggs in a number of different baskets.
Ways to Diversify
There are a number of ways to diversify your investments:
- By Asset Class
- By Sector or Industry
- By Geographical Region
- By Investment Strategy
In the simple example above we looked specifically at Equities, or Shares in a company. This is one type of “asset class”. You can diversify by mixing Equities with Bonds, Real Estate, Cash and Commodities.
You can further diversify by Sector as demonstrated above by selecting investments from Technology, Pharmaceutical, Utilities and so forth. And again by geographical region to include UK Equities, US Equities, Europe, Japan and Asia.
And, if you want to, you can combine Passive and Active funds and diversify once again by investment strategy. Passive funds simply mimic the performance of a given index (eg FTSE100) whereas Active funds benefit from a fund manager actively making decisions about the individual investments for you. So you can combine both investment approaches as a further way of diversifying.
In short, diversification is a way of reducing the overall risk to the money you invest, meaning any impact of loss will be felt less heavily. With fewer losses this will in turn increase the opportunity for overall investment growth.
There is a counter argument that too much diversification can limit the potential for growth in the short term, so understanding your own preferences for how much risk you want to take and your personal situation is important.
Funds as Diversification
Buying lots of small pieces of shares and bonds in different sectors and different locations can become quite costly with dealing fees. It can also be a challenge to ensure each of your individual investment choices is diversified well enough without over-diversifying, whilst still matching your own attitude to risk. The research required can be time consuming and overwhelming.
This is where Funds come into their own.
A fund manager has curated the investments for you, so each fund will have multiple companies and potentially multiple asset classes. Some will specifically focus on one objective for example a technology fund, sustainable fund, emerging company funds, whilst others will be more broad ranging.
As a beginner investor, consider looking for broad diversified funds as a starting point. As your knowledge and experience builds, assuming you have the risk tolerance and ability to withstand a potential loss, then you could consider individual shares in the future.
- Diversification is a risk management strategy that reduces the risk to your overall investments
- Portfolios can be diversified across asset classes, sectors, location and investment approach
- Diversification can potentially reduce performance in the short term.
Remember, investments go up and down in value so you could get back less than you put in.