What is diversification?

A common mistake many investors make is to expose themselves solely to one asset. This means they put all their allocated funds into a single financial instrument, often because they strongly believe in it. However, like the saying goes, putting all your eggs in one basket is rarely a good idea.

More often than not, a strategy like this proves less than successful, as it makes all of the invested funds vulnerable to the risks particular to that asset. For example, if you purchase shares of one company’s stock and that company subsequently becomes insolvent, all of your invested money would be gone. But if you had built a portfolio, where your funds were split between different sectors, stocks, ETFs, and commodities, then a single company’s demise would have affected only a small percentage of your total investments.

This is called diversification. It is a strategy, meant to manage your portfolio’s risk and minimize potential losses, caused by market volatility, corporate events, or industry changes. Simply put, the rationale is that within a diversified portfolio, the positive performance of one asset will offset the negative performance of another.

An easy way to start expanding your portfolio, while reducing risk, can be to buy ETFs or mutual funds. These instruments allow you to invest in a multitude of companies, without having to purchase their shares individually, meaning you’ve diversified your portfolio with a single investment.

In order to truly diversify effectively though, an investor must include different types of assets. Even further, one can diversify by purchasing assets and commodities from different countries and industry sectors. This way you’re limiting your exposure to any one single asset and its associated pitfalls.

It’s important to remember that diversification does not offer a guarantee for profit or absolute protection from loss. Its purpose is not to maximise returns. What it does is minimize the risk of detrimental blows to your portfolio during down-swings of the markets and thus it is essential to a balanced and well-rounded investment strategy.