Portfolio diversification is key to mitigating risk when investing

Investing in a diverse range of assets, sectors and companies will help mitigate risk and prevent investment portfolios from suffering total financial loss.

With every investment comes some form of risk, be it low or high, as an investment portfolio grows, the risks build up. There is one great investing strategy that can be used to mitigate risks, and that is diversification. By having a diverse portfolio, the investment money is not concentrated in a single asset class, sector, or company, but rather, it’s spread across a range of different asset classes, sectors, and companies.

Each investment portfolio acts as a financial map and its future heavily relies on its diversification. Before making any investments, it’s essential to explore all the different options, including different company sizes and geographical locations, and adjusting accordingly to mitigate risk. There are multiple ways to diversify a portfolio, each of which has their own advantages and disadvantages that need to be considered, from investing in different types of assets and industries to the locations and sizes of individual companies.

Don’t Put All Your Eggs in One Basket

In layman’s terms, diversification of a portfolio means “not putting all your eggs in one basket”. Spreading investments across different types of regions, securities, businesses, and industries is a winning strategy. By not keeping all your investments in one place, it is theoretically impossible to completely lose in all your investments. Furthermore, diversification offers stronger, long-term returns and has been shown to maximise overall return.

How Does Diversification Mitigate Risk?

Mathematical models have shown that diversification is a winning investment strategy in offsetting risk exposure since it offers a form of guaranteed protection against any significant losses. This is achieved by starting from the top, by first diversifying across different asset classes, such as bonds, stocks, and private equity. Professionals say that there is a negative correlation between bonds and stocks, meaning that they move in the opposite direction, so when bond yields are rising, stock prices are usually falling. Investing in both types of assets mitigates the risk of only losing.

Your portfolio can then be further diversified within each class, i.e., across multiple sectors and industries. A diverse portfolio provides something to fall back on when a single industry takes a hit, as opposed to one that consists of investments in one industry alone. This is true for any industry, be it tech, energy, or pharmaceuticals, it’s always best to spread investments across different companies in different industries.

The Importance of Mitigating Risk

Markets are constantly changing, and the future is highly uncertain, therefore it is necessary to minimize investment risk, and invest in a diverse range of things that are not exposed to the same risk, thus mitigating the risk of total loss. It’s impossible to predict how any one industry or company will perform, the key is to have a portfolio with a variety of investments that perform differently in similar markets, rather than buying assets that move in lockstep with one another.

It’s important to research each sector ensuring that you’re investing in the sectors that are most likely to grow in the future, not forgetting that different sectors will be affected by different economic situations. Investing in companies that operate in different sectors, e.g., healthcare and automotive industries, reduces the dependency on a single sector thus mitigating the risk.

Understanding How To Diversify An Investment Portfolio

We’ve already discussed spreading investments across different asset classes. Having money in investments with different returns and risks is the first step to diversifying a portfolio. The next step is to diversify across different industries and sectors. A portfolio that already has investments in companies in the healthcare industry may consider investing in a company that manufactures products in the automotive industry. For example, the S&P 500 consists of stocks of companies in 11 different industries, ranging from consumer staples and real estate to energy and communication services.

Not only is it important to invest in companies in different industries, it’s also critical to diversify the sizes and locations of the companies. Consider investing in both small startups as well as big and developed companies. Investing across a diverse range of countries with different currencies will mitigate risk from a political and economic standpoint. As a result, diverse portfolios tend to outperform more focussed portfolios over time.

A Diverse Portfolio Will Protect You

The importance of mitigating risks is of great benefit. While there may still be loss in some places with a diverse portfolio, there will never be an overall loss across the board. For example, in the 2007-2009 global recession, industries such as real estate were heavily affected, but other sectors such as healthcare were left untouched.

The world is a big place, and there are different trends everywhere, meaning it’s always safe somewhere.  Evaluate the risks of each geographical location and allocate your investments throughout different countries. A diverse portfolio protects you from high risk, and overall has beneficial outcomes with better long-term success and returns.