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What is diversification?

Now and again, you’re going to get it wrong. Even one of the most famous investors Warren Buffett has made a mistake or two. It’s why diversification is crucial to any portfolio.  

No matter how confident you are, going all in on one investment is a dangerous game to play. Whilst your investment could surge five-fold, it could also vanish before your eyes. With nothing else in a portfolio, this strategy is incredibly risky and leaves an investor exposed to any movement in the value of their holdings.

Risk is found everywhere and can affect companies, industries and entire asset classes. You might think it’s safer to stay out of the market altogether, but even then you risk losing money to inflation.

Lower risk, higher returns?

Don’t worry, it’s not all doom and gloom; risk can be reduced through diversification across investments.

As the three main asset classes – equities, bonds and cash equivalents – rarely perform in line with each other, careful portfolio construction based on attitudes to risk can help maximise returns, according to modern portfolio theory.

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By making an investment, your capital is at risk.

Looking to smooth out sector-specific risks, a well-balanced portfolio should offset any negative performance with the positive. As long as a portfolio’s assets don’t perform in a similar way, this strategy is lower risk and leads to higher returns than any one, single investment.

Including equities, bonds and cash equivalents, a well-diversified portfolio should have investments that span across sectors and geographies so the losses in one asset class can be counteracted by the gains in another. A portfolio might include exposure to commodities, currencies, health care and real estate, for example.

Challenging for the normal investor

Investors with limited budgets can find it hard to create a truly diversified portfolio. It’s also a tricky thing to get right; successful asset allocation needs time, good knowledge of industry trends, and the ability to value all asset classes.

Those who want portfolio diversification but lack the resources are increasingly turning to funds. Investors can get exposure to traditional markets and even access more unusual sectors through low-cost ETFs.

Diversification is something we take seriously at Moneyfarm. Depending on the size of an investment, our portfolios typically hold between 7-14 funds, diversified across geographies and asset classes. The low-cost nature of ETFs make this asset allocation possible.

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