Portfolio diversification: what is it and why is it so important?

Posted on 18th August 2022

If you’re an investor, you will almost certainly be exposed to a degree of risk when buying and selling stocks, shares, forex, or any other security. Reducing this risk is paramount to making sure your investments turn a profit, and one of the best ways to do so is via portfolio diversification.

In this guide, learn what portfolio diversification is, why it matters, and how you can diversify you investment portfolio.

What is portfolio diversification?

Portfolio diversification is the process of building an investment portfolio full of securities which are different to one another. By having investments within different niches, industries, asset classes, and security types, if negative economic shocks affect a single company or industry, then your portfolio will be less likely to significantly lose value.

This approach works for day trading securities too. If you engage in CFD trading, for instance, having a diversified range of trades open at any given moment can shelter you from unpredictable swings in the value of individual assets.

The importance of diversification

The reason diversification matters is all down to risk. Less diversification, and the chances your investments will be negatively affected multiplies. The
Australian Investors Association outlines five key types of risk – all of which can affect those with poor diversification.

Volatility – It’s impossible to predict the value of some securities. Values can drop precipitously, and if all your money is in the one stock that drops, then you’ll lose out much more than if you had
a diversified portfolio.

Knowledge – If you don’t have all the information on a company or industry, you may get caught out. Diversification stops this from happening.

Events – Disasters, economic crashes, policy changes; a lot of unknowns can affect single stocks.

Credit risk – If you own shares and a company folds, you may not get your money back; if you diversified your portfolio, you won’t lose all your money.

Sleep-at-night factor – If you’re not diversified and your stocks are hit by bad economic news, then you’ll likely feel poor mental effects. Diversification can help the situation feel less
bleak.

How to diversify your portfolio

If you want to diversify, there are some quick ways you can do so.

First, consider asset allocation based on your age and lifestyle – if you’re young and have no family, go for riskier assets like tech stocks. Older with a large family, safer assets like US government bonds. Next, assess the risks to any investment before you commit, and make sure to hold onto investments for long enough time so they can grow.

Lastly, learn about the markets and economy – more information equals a higher likelihood of picking better and more varied investments.

Diversifying your investment portfolio is a great way to protect your money from risk. With the global economy facing all manner of threats, be sure to analyse your portfolio today and take steps to diversify – your financial future could rely on it!