When considering an investment, you have probably heard the expression “Don’t put all your eggs in one basket.” Yes, we’ve heard it over and over. If you want to make money and avoid big losses, you have to diversify. But what makes a diversified portfolio and what are the best ways to diversify your portfolio?
Before we answer these questions, you need to understand what diversification means and why it is important to all investors.
Once you understand the full benefits of diversification, you’ll find it easier to start practicing it in your own life. Contrary to popular belief, diversification isn’t something that’s difficult to do. You simply need some good financial guidance and a healthy dose of patience. Diversifying your portfolio won’t bring you quick returns, but it will steadily help you build wealth over time.
What is Diversification?
According to Investopedia, diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. Although it does not guarantee against loss, diversification aims to maximize return by investing in different areas that would each react differently to the same event.
“Diversifying your investments is important because it’s extremely difficult to know which investments will perform best, especially in the short-term,” says Mike Palazzolo, CFP and founder of the Detroit-based financial planning firm Fintentional. “When you diversify, you spread your investment across many companies around the globe.”
Sounds pretty simple, right? So, why are there still so many savvy individuals are not diversifying their portfolio and putting all their eggs in one basket? The only possible explanation is that they don’t understand the benefits of diversification.
The three key advantages of diversification:
- Minimizing risk – One of the key advantages of diversification is that it will help you to minimize risk. This is because a diversified portfolio is not overexposed to a single industry and therefore is somewhat insulated from downturns and volatility – or market fluctuations – in that industry.
- Maximizing return – In addition to limiting downside risk, diversification also have the effect of maximizing portfolio returns. Sometimes, investments don’t always perform as expected. By diversifying, you’re not merely relying upon one source for income.
- Preserving capital – not all investors have the same risk tolerance – there are some investors who are close to retirement with goals oriented towards preserving their capital. Diversification can help to protect your savings.
What makes a diversified portfolio?
As mentioned earlier, to diversify your portfolio you need to spread your capital across different asset classes to reduce your overall investment risk. These should include a mix of growth and defensive assets:
- Growth assets include investments such as shares or property and generally provide longer term capital gains, but typically have a higher level of risk than defensive assets.
- Defensive assets include investments such as cash or fixed interest and generally provide a lower return over the long-term, but also generally a lower level of volatility and risk than growth assets.
A diversified portfolio means spreading risk by investing:
- across different asset classes such as cash, fixed interest, property, local and international shares
- within asset classes such as purchasing shares across different industry sectors
- across different fund managers if investing in managed funds.
Generally, particular investments or asset classes will perform better than others over a specific period depending on a range of factors including:
- current market conditions
- interest rates
- currency markets.
No particular investment consistently outperforms other investments.
For example, during periods of increased share market volatility, your share portfolio may suffer losses. If you also hold investments in other asset classes such as fixed interest or direct property that may perform better over the same period, the returns from these investments can help smooth the returns of your overall investment portfolio.
So, by diversifying your investments, you can achieve smoother, more consistent investment returns over the medium to longer term.
There are several ways you can diversify your portfolio. One of them is through Structured Notes. At NEBA Financial Solutions, you can build your own diversified portfolio by combining a number of individual stocks or indices. In general, buying stocks or indices that differ in size, industry, geography, and corporate strategy can give you more of the benefits of diversification.
The Bottom Line
Remember that no matter how diversified your portfolio is, risk can never be eliminated completely. Even the best analysis of a company and its financial statements cannot guarantee that you won’t be losing an investment. A diversified portfolio will cushion the blow of a downturn and help you avoid the full consequences of making an unfortunate stock selection.
If you are an investor, speak to your financial advisor on how you can build a well-diversified portfolio by investing in NEBA’s structured notes or UCITS Funds. Your financial advisor should provide guidance as to what you are looking to achieve and which investment strategies is the most suitable for you.
Visit www.nebafinancialsolutions.com to see our Structured Products and UCITS Funds http://www.nebafinancialsolutions.com/Risk-Rated-Portfolio-DFM, http://www.nebafinancialsolutions.com/real-asset-fund