Most investors know that it rarely makes sense to have all their eggs in one basket, but what does it mean to have a truly diversified portfolio, and what are the benefits?
Diversification can mean different things to different investors, but it usually comes down to the same objective – reducing the volatility of your overall investment while helping you achieve your goals. When it comes to managing our clients’ portfolios, we like to diversify in three ways:
Hold a blend of asset classes
Investable assets come with many different levels of risk attached to them. Take for example fixed income and equities. Simplistically speaking, fixed income assets (the ownership of a government or company’s debt), are deemed to be lower risk investments which fluctuate less. Equities (the ownership of shares in a company), on the other hand, are deemed to be higher risk as their prices fluctuate more significantly and there is no guarantee you will get your money back if the company goes bust. As a rule, equities and bonds have a low correlation to each other and therefore a blend of the two is required to ensure that, if one is going down, the value of your portfolio is protected to some extent by the other.
Nowadays investors have access to a multitude of different asset classes including commodities, property and alternatives (such as hedge funds and derivatives). A combination of all of these can complement the portfolio.
Maintain geographic diversification
Different regions and countries vary hugely when measured against a broad set of metrics. For instance, how developed are their financial markets? How stringent are their regulations? What is the country’s growth potential and what political risks are present now or foreseen in the future? Different regions also demonstrate very different qualities in terms of demographics, productivity and development. These factors must be considered when investing, and it’s important to ensure that risk is spread. For example, a holding in emerging markets may see very good long-term performance but with high levels of volatility, whereas an investment in the UK or the US may see lower long-term growth, but with much less fluctuation in prices. Different regions must then be included to the extent that they match your objective and tolerance to loss.
Hold investments across a range of sectors
Companies in different industries will be subject to differing drivers and economic cycles. For instance, technology companies will not have the same return profile as global mining companies, nor will banks or insurers perform in line with pharmaceutical and healthcare firms. Ensuring that your portfolio is protected from weakness in these varying markets requires a blend of companies which will perform well in a variety of different market conditions.
This might sound hard to achieve, but a little help from your portfolio manager can go a long way to ensuring that you achieve sufficient diversification and that you meet your investment objectives, whatever they might be.