What is diversification?

Diversification involves thoughtfully distributing an investor’s financial investments across various asset classes and economic sectors. These should be unrelated and show low levels of return correlation.

The purpose of diversification is to mitigate the overall investment risk, recognising that different assets and sectors can react differently to changing market conditions. This approach assumes that losses from one investment can be offset by gains from others.

How diversification helps to reduce the impact of volatility

Volatility is indicated by price fluctuations over a specific period. It stems from economic, political, and corporate events, as well as natural conditions.

Diversification helps mitigate the impact of volatility on investment portfolios. While one asset or sector in an investment portfolio may sustain losses due to volatility, others can show better performance, thereby mitigating the overall portfolio losses.

Advantages of diversification

  • Risk reduction. Spreading investments reduces dependence on specific assets or sectors, minimising the risk of losses
  • Income stability. Diverse assets balance return fluctuations, ensuring a more stable cash flow
  • Growth potential. A diverse investment portfolio enables a better understanding of various market and economic aspects, capturing growth opportunities in multiple sectors
  • Portfolio stability. Diversification contributes to building a resilient portfolio, crucial for long-term financial goals
  • Emotion management. Distributing investments reduces the likelihood of impulsive reactions to short-term market fluctuations

Drawbacks of diversification

  • Limited profit potential. Diversification might limit the potential for generating maximum returns if one asset experiences rapid growth
  • Complex portfolio management. Handling numerous assets in a portfolio makes it complicated to manage funds as it demands more time and effort for continuous monitoring, analysis, risk assessment, and rebalancing
  • Increased costs. The diversification of a portfolio requires more asset buying and selling operations for the purpose of rebalancing, which may involve additional fees and costs

Diversification classification criteria

  • By asset class. Allocating investments across stocks, bonds, currencies, commodities, and other types of assets
  • By industry. Investing in companies across different industries and sectors of the economy
  • By company market capitalisation. The portfolio may comprise securities of companies with large, medium, and small market capitalisations
  • By geographic location. Distributing investments among various regions and countries
  • By investment style. Focusing on companies with high growth potential (growth stocks) and undervalued companies (value stocks)
  • By timeframe. Distributing among short-term, medium-term, and long-term holdings