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What is portfolio diversification?

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Last editedOct 20202 min read

“Don’t put all your eggs in one basket” might be a proverb dating back to the 1600s, but when it comes to portfolio management, it’s also a cast-iron rule that you should ignore at your peril. Portfolio diversification can help you manage risk and ride out crises and economic downturns. Get the inside track on the different types of diversification in portfolio management, the importance of portfolio diversification, as well as the pros and cons of implementing an investment portfolio diversification strategy, right here.

Understanding portfolio diversification

Portfolio diversification is a simple concept. In essence, it refers to the practice of investing your money in a range of different securities and asset classes, thereby minimising your overall level of risk. For example, if all of your capital is invested in a single security, one dip in the market could lead to the loss of your entire investment. An investment portfolio diversification strategy can lower the volatility of your portfolio and smooth out your returns. 

Types of diversification in portfolio management

If you want to start using an investment portfolio diversification strategy, there is a broad range of different asset classes that your portfolio should include. In addition to domestic stocks, the main components of a diversified portfolio are international stocks, bonds, and short-term investments. Other important types of diversification in portfolio management include commodity-focused funds, real estate funds, sector funds, and asset allocation funds. Ensure that your portfolio has a healthy mix of these components to take advantage of the effects of diversification on portfolio risk.

The importance of portfolio diversification

There is a broad range of benefits of portfolio diversification. Most importantly, the effects of diversification on portfolio risk cannot be understated. Portfolio diversification helps to shock-proof your investments, so if the market experiences a downturn, you can contain your losses more effectively. Furthermore, portfolio diversification can help you to leverage growth opportunities in different sectors/industries. If all your assets are in one sector, you won’t be able to take advantage of bullish runs in another industry. Finally, an investment portfolio diversification strategy can provide you with stability and peace of mind, so there’s no need to worry too much about instability in the markets.

Drawbacks of portfolio diversification

While there are many benefits of portfolio diversification, it’s important to remember that there are also disadvantages. Firstly, it’s important to remember that by diversifying your portfolio, you’re running the risk of investing in an unknown asset. If that investment ends up making a loss, it reduces the returns of your overall portfolio. In addition, spreading your investments across different sectors means that – if a single sector experiences a significant spike – you won’t benefit from leveraging total gains from the sector. Finally, using an investment portfolio diversification strategy can increase the complexity of your investments and lead to tax complications, which can be challenging to deal with.

The best investment portfolio diversification strategy

Want to experience the benefits of portfolio diversification for yourself? Firstly, you’ll need to spread out your investments across a broad range of stocks from a range of different sectors and industries. You should also explore some of the other asset classes we mentioned above, including bonds and real estate. The bond and equity markets usually move in opposite directions. By investing in both asset classes, you can offset negative results in one market by positive results in the other. Another crucial element in any investment portfolio diversification strategy is knowing when to exit an investment. If the asset isn’t performing and it doesn’t align with your goals, it may be time to get out.

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