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What is diversification?

Now and again, everyone gets things wrong. Even the world’s most prolific, astute businessmen have made a mistake or two in their careers and in their investments. This is why, at least in the context of investing, diversification is crucial.

No matter how confident you are, going all-in on one investment is a dangerous game to play. While a given investment could surge five-fold, it could also drop significantly in value. With nothing else to support a portfolio, this is a risky strategy that leaves the investor fully exposed to any movement in the value of their holdings.

Risk can be found everywhere and affects companies, industries and entire asset classes alike. 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 – don’t often perform in line with each other, careful portfolio construction based on attitudes to risk can help maximise returns, according to tried and tested portfolio theory.

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

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

How easy is diversification?

In short, the answer is ‘not easy at all’. 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 takes time, knowledge of industry trends, and the ability to evaluate all asset classes within their contexts.

Those who want a diversified portfolio but lack the resources to create one are increasingly turning to funds. Investors can get exposure to traditional markets alongside more unusual sectors through low-cost ETFs.

Diversification is something we take seriously at Moneyfarm. Depending on the size of an investment, our portfolios hold a number of different, diversified across geographies and asset classes. The low-cost nature of ETFs makes this asset allocation possible and is a large part of our investment strategy. 

Ultimately, the best thing you can do is employ a professional to diversify your portfolio for you. At Moneyfarm, for example, we assign diversified portfolios to investors based on their attitude to risk, their time horizon, and a number of other factors. See how you could benefit from a fully diversified investment portfolio today.

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