‘ PortfolioDiversification’ is a word that gets thrown around by financial professionals. But what does it actually mean? And can it actually help you to achieve your financial goals?
Let’s tell you a bit about Tom and Mitch – they will help you understand the importance of portfolio Diversification:
Meet Tom – he plants bananas because everyone in his neighborhood loves bananas. They sell like crazy! His neighbor Mitch decided to grow bananas, oranges, apples, and lemons. People kept telling him he should focus on bananas – they will bring him a higher yield. One day the moisture level changed (humm…) and the bananas were all ruined. Guess who had fruits on the table by the end of the day?
Planting many different species of plants and fruits ensures that the farmer doesn’t suffer complete ruin when the weather is unpredictable. Same with your investments.
What exactly is portfolio diversification?
For thousands of years, successful investors have relied on an idea called diversification.
Portfolio diversification is a pretty simple concept. When you diversify your portfolio across a number of different investments, you lower your overall risk. This is key to generating wealth over the long run, since it prevents you from getting wiped out if markets turn against you.
So, portfolio diversification is simply a way of spreading risk, otherwise known as ‘not putting all of your eggs in one basket’. In this case, think of different investments as different baskets.
The importance of portfolio diversification
Diversification happens on many levels within a portfolio.
- Diversification by geography means spreading your money around different global markets so if one falls, you’re less likely to experience a significant loss to the value of your portfolio. This is because different economies exhibit different economic conditions, which in turn drive investment performance. So, rather than putting all your money in an ETF that tracks the US stock market, you might decide to put a portion in US stocks, a portion in European stocks and a portion in Asian stocks.
- Diversification by asset class is another important aspect to consider. This means investing in a variety of assets – including stocks, bonds, cash, gold, property – to minimize the risk that one asset class might underperform and harm the performance of your portfolio. We actually do this intuitively when we buy a house, or pay into an employer’s pension scheme, or invest in a friend’s startup. So it’s worth considering your overall exposure to different asset classes over and above what’s in your stocks portfolio.
- Truly effective portfolio diversification also requires awareness of company-specific diversification, which mitigates the risk that a high concentration of a specific stock within a portfolio will hurt overall performance. It pays to be invested in a diverse range of securities within a given market geography or asset class.
- Timing is another important consideration. Adding to your investment portfolio in a slow and steady way will enable you diversify the risk of buying into the market at the so-called “wrong” time.
Diversify to accumulate
Diversification is simple to understand but hard to master. It’s certainly achievable, but unless you’re a professional investor with the time and experience to construct a truly diversified portfolio that caters to your unique financial objectives, it can be tough to get it right.
At Sarwa we’ve built a platform that does this for you, enabling you to diversify your investments in a painless and affordable manner. Our approach draws upon the work of top investors and academics to create a healthy balance of investments that minimizes portfolio risk, giving your money the greatest chance of growing over time.
Ready to invest in your future?