Diversification is a way to try to reduce the risk in your portfolio by choosing a mix of investments. Under normal market conditions, diversification is an effective way to reduce risk.
If you hold just one investment and it performs badly, you could lose all of your money. If you hold a diversified portfolio with a variety of different investments, it’s much less likely that all of your investments will perform badly at the same time.
The profits you earn on the investments that perform well offset the losses on those that perform poorly.
For example, bonds and stocks often move in opposite directions.
When investors expect the economy to weaken and corporate profits to drop, stock prices will likely fall. When this happens, central banks may cut interest rates to reduce borrowing costs and stimulate spending. This causes bond prices to rise. If your portfolio includes both stocks and bonds, the increase in the value of bonds may help offset the decrease in the value of stocks. The reason for including bonds in a portfolio is not to increase returns but to reduce risk.
In theory, diversification enables you to reduce the risk of your portfolio without sacrificing potential returns. An efficient portfolio has the least possible risk for a given return. Once your portfolio has been fully diversified, you have to take on additional risk to earn a higher potential return on your portfolio.
There are four reasons to diversify.
- Not all types of investments perform well at the same time.
- Different types of investments are affected differently by world events and changes in economic factors such as interest rates, exchange rates and inflation rates.
- Diversification enables you to build a portfolio whose risk is smaller than the combined risks of the individual securities.
- If your portfolio is not diversified, it will be unnecessarily risky. You will not earn a higher average return for accepting the unnecessary risk.
One way to diversify your portfolio is to invest in several asset classes.
The three main asset classes are:
- Cash and cash equivalents
- Fixed income investments [bonds]