If you’re a novice investor, you have probably heard the term ‘diversification’ bandied about a few times, often extolled as an identifier of a strong portfolio. However, while many people understand the importance of diversification, few people understand what this truly means in practice.
A diversified portfolio is more than just a physical description of a portfolio that contains a variety of assets and interests. It is a long-term investment strategy that requires a strong ability to assess risk and identify opportunities as they arise. Let’s take a closer look at the central tenets of diversification, as well as some examples of when it has been done the right way.
What is diversification?
First, let’s explain what diversification is and why it is such an important part of any investment strategy. As this comprehensive guide to trading stocks and shares explains, there are many different factors that affect the daily price fluctuations of certain assets, with market sentiment being chief among these. Market sentiment is what leads to speculative bubbles, which can and invariably do ‘pop’ at some point, depreciating the price of the asset being speculated upon.
Diversification is a way to shield your portfolio from the ravages of the market, by guaranteeing that a price crash of a particular stock or asset does not wipe you out. It is a way of hedging your bets and multiplying your chances of success and profit. It means spreading your capital across a broad range of stocks and shares that represent a wide variety of different industries so that a bad day for one industry does not mean a bad day for your entire portfolio.
Top diversification tips
There are many diversification tips that you can take with you from the outset. You can start by creating a mutual fund to spread your wealth across a small but diverse number of stocks. It is important never to overstretch yourself; it is better to invest in 20 companies that you know a lot about rather than 200 companies that you have barely heard of.
You should also include investments that act as a buffer against market volatility, which is why index funds are such a popular choice for seasoned investors. Index funds allow you to track various stock indices around the world and automatically invest in them. Returns are not as substantial, but it will significantly reduce the overall risk that your portfolio is carrying.
Diversification done right
Now let’s think of an example of diversification’s benefits in action. For this, we’ll use the example of Warren Buffet, the hedge fund guru who is widely considered to be one of history’s most successful investors.
During the 2008 market crash, which was largely triggered by the subprime mortgage crisis, Buffet’s holding company Berkshire Hathaway had hundreds of millions of dollars invested in mortgage providers, meaning that the company’s portfolio took a substantial hit in the aftermath of the crisis.
However, Buffet’s portfolio also included a wide range of assets that performed well after the crash, including high-tech companies and energy giants. More importantly, Buffet was quick to invest in struggling Goldman Sachs, which nearly declared bankruptcy during the crisis.
As a result of this investment, Buffet made a profit on Sachs shares of around $3.7bn in 2011. This demonstrates the importance of taking reactive investment decisions when diversifying your portfolio.