The benefits of diversification
When talking to financial advisers about where you should invest, you will often hear them use the term diversification, but what does this mean and why is it so important? The US stock market NASDAQ defines portfolio diversification as “investing in different asset classes and in securities of many issuers in an attempt to reduce overall investment risk and to avoid damaging portfolio performance by the poor performance of a single security, industry or country.” In short diversification within a portfolio is using a variety of funds, assets and securities to spread your investment risk. Below we look at three advantages of diversification.
When investing, there are two types of risk, systematic and unsystematic. Systematic risk influences a large number of assets. A significant global event, for example the 2008 financial crisis, could affect several of the assets in your portfolio. It’s very difficult to protect yourself against this type of risk and some would argue almost impossible. Unsystematic risk, sometimes called specific risk, relates to specific hazards that affect a company, industry or region. For example a group of employees going on strike will affect specifically the shares in that company, but will not affect the market as a whole. An individual who holds only shares in that company will be exposed to unsystematic risk.
As unsystematic risk doesn’t affect the market as a whole, it can be mitigated by diversification. Holding shares in lots of companies, rather than just one, mitigates the risk of, for example, employees striking in one company. This is one of the greatest benefits of diversification as it allows you to invest in such a way that you “diversify away” risks that are inherent in single companies. On a larger scale it also allows you to mitigate risks inherent in single sectors, asset classes or regions.
For some investors the preservation of capital is more important than the potential growth in capital. Especially if the investor is drawing down from the investment. By using diversification investors can allocate money to different assets and sectors, allowing for a smoother overall return and mitigating losses from specific investments.
Diversification will reduce the volatility of the portfolio, which will mean the highs and lows associated with investing in specific equities will be reduced, providing a steadier return. This return results in the preservation of capital.
Hedging major global events
Political, economic and natural events will happen in different countries at different times and to a varying degree of severity. As an investor you cannot stop these events happening, however you can hedge them with good diversification. By investing in many different regions and asset classes, you can mitigate the effect of a major global event. A great example of this is the strong performance of US equities over the last few months in contrast to weak UK and European equity performance after the BREXIT referendum. If your portfolio consisted of both U.S. and UK equity, the losses from the UK could be offset by the gains in the U.S. There are numerous examples of regional political unrest or natural disasters affecting asset prices, but a well diversified portfolio being adequately hedged will absorb the losses from a particular incident.
Although we have focused on just three here, there are many benefits of diversification within a portfolio, all of which help with a more stable, risk averse and well balanced portfolio. Although Diversification can not guarantee reducing losses, or increasing returns, any intelligent investor should always look to diversify their investments, incorporating a variety of asset classes and constructing a well balanced and durable portfolio.
The value of tax reliefs depends on your individual circumstances. Tax laws can change. The Financial Conduct Authority does not regulate tax advice. The value of your investment 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. Occupational pension schemes are regulated by The Pensions Regulator.