Imagine filling your basket with all of your eggs, then you trip over the cat. Kitchen’s a mess, you’ve ruined breakfast and made an enemy of the cat. You leave a couple of eggs in the carton, some in the fridge, and the outcome is different. Maybe the cat still hates you, but you’ve hedged your bets and you’re looking at life sunny side up.
When it comes to investing, one of the most important principles to understand is diversification. Diversifying your investments can help you to get your portfolio on the same page as your risk tolerance, and reduce your chance of big losses. In this article we’ll answer why diversification is important, how to diversify your investment portfolio, and look at some examples of doing this.
What does it mean to diversify your investments?
Diversification at its core is an investment strategy. Diversifying your investments means owning a wide variety of investments with different properties that respond differently to influences. The goal of diversification is to reduce the impact of any one investment’s poor performance on your overall portfolio.
Think of it like running a store that sells ice creams or hot chocolate. Diversifying and selling both options means your offerings will perform quite differently on sunny days, and cold ones. But what if summer doesn’t come (again) this year and you’re left holding the ice creams while next doors’ pure-play hot choc shop is killing it? Yep, there are both pros and cons to diversification.
Why is diversification important in investing?
The number one pro reason for diversification is to lower your risk - or reduce the chances of experiencing large losses. Because you have exposure to several different assets or investments, if one hits the fan, others may offset the losses and overall you’ll be better off.
Another somewhat less mathematical reason is that some investors enjoy exploring multiple investments because it makes investing more fun. It might not make you more fun at parties, but things that help you to stay engaged and encourage you to learn more shouldn’t be discounted if they keep you motivated towards your financial goals.
Variety is the spice of life, but just like too many snakes can ruin a plane trip, wrangling a large number of portfolio holdings can also have its drawbacks. One of the cons of diversification is that it can be extremely time-consuming researching shares in multiple different companies, and managing a menagerie of different holdings.
Multiple transactions to buy and sell your many diverse holdings, and paying brokerage fees can also get expensive (especially if your broker doesn’t have a flat fee structure like Hatch does). This is why it can be tricky to see how a beginner investor can have a diversified portfolio (more on this later!). There are pros and cons to diversifying your investment portfolio but basically it works both ways; it lessens the risks but it can also lessen the rewards.
How to build a diverse investment portfolio
To build your own diverse portfolio you’ll need to look at investments across different asset classes, industries and countries. If you want to get super technical you can go even deeper and diversify within asset classes. For stocks, you might look into company size (small and big market cap), and for property it could be exploring commercial and residential - diversity comes in many forms!
Before you start buying up large, you need to decide on your risk tolerance, your investment goals and your time horizon. Once you’ve got that nailed down you can look at what percentage of your portfolio you’d like to allocate to each asset class such as stocks, property, bonds, cash etc, so that it fits with your investment goals.
If this sounds like a lot of work, or if you’re just starting out on your investing journey, a way to get some diversity instantly is by investing in Exchange-traded funds (ETFs). ETFs are like baskets filled with different investments, such as shares and bonds. If you invest in an ETF, you buy a share of the whole container (basket) and own a tiny slice of every investment contained within it. ETFs can be thematic or specific to an industry, so keep this in mind if you’re looking for more than just diversity within a sector.
Examples of portfolio diversification
Remember, choosing how to diversify your investments depends on your individual circumstances, risk tolerance and investment goals. Examples of portfolio diversification can be found everywhere; if you’re an NZ tax payer, think about when you selected your Kiwisaver fund. Most providers have options or ‘risk profiles’ that look something like this;
- Defensive
- Conservative
- Moderate/ Balanced
- Growth
- Aggressive
Sorted has an excellent investor profiler tool that demonstrates what mix of investments might be most suitable for your goals when looking to diversify your assets. A conservative portfolio would have a majority percentage of bonds and cash which are considered less volatile. An aggressive portfolio might be heavily weighted towards single stocks which have higher growth prospects and are more volatile, but within that asset class it will likely still be diversified by investing across different sectors and countries.
As your goals change, it might be necessary to rebalance your portfolio. Using a portfolio diversification calculator or investor profiler tool like Sorted’s can help you to get a visual picture of how diversified your investments are, and decide if it is the right mix to achieve your financial goals.
Is it possible to be diversified as a beginner investor?
When you’re a beginner investor, trying to have a diversified portfolio straight away can be a barrier to getting started (like there aren’t enough already!). As we touched on earlier, diversification comes with both pros and cons and one of those cons can be multiple transaction and brokerage fees.
While you’re building up your investing lingo, your research skills and your confidence, you should be aware of the long-term effect that compounding growth can have on your investments, and how paying a lot of fees can eat into your returns. Many beginner investors choose to start their portfolio with a small set of highly diversified exchange traded funds. As with everything when it comes to investing, you can start small and add more over time as your knowledge grows.
Building a diverse investment portfolio is crucial for managing risk and potentially having something slightly interesting to talk about at parties. By diversifying across different asset classes, industries, and geographic regions, you can reduce the impact of any single investment's poor performance and increase your chances of reaching your financial goals.
