When investing it is common practice to diversify your portfolio to minimize risk. It is almost impossible to predict how financial markets will perform and each asset class (such as cash, bonds, property and shares) has their own business cycle. By diversifying your investments you can take advantage of the ‘ups’ while restricting the ‘downs’.
Diversifying a portfolio means investing in different asset classes as well as investing in a number of securities within each of the asset classes. In the share category your strategy would be to hold a number of different companies as well as including overseas shares. Those companies would also represent different industries as they will also have their own business cycle.
The basis for diversification is that even if one or two of your investments go bad, you will have plenty of others providing you peace of mind and avoid losing it all.
Not only does diversification help to protect your funds it also helps to smooth returns. A portfolio with only one share is likely to have returns that fluctuate wildly, while a portfolio that holds a range of other shares and asset classes will have more reliable and less volatile returns.
Diversification only reduces and does not eliminate risk. Most of the time shares move together so the only true way to diversify your share or property portfolio is to also hold funds in cash and in bonds as these assets usually perform at different times of the market cycle.
All investments are subject to risk, some more than others. The more you diversify the more likely you are to reduce this threat. If you had all of your money in just one share and that company you invested in didn’t perform you would make a loss. However if you have spread your money across different types of investments you have a better chance of including some investments that will perform.
Remember that while lowering the threat of total loss of the investor; diversification does not lower the possibility of the underlying investments suffering a loss. Risk is a matter of market trends, economic trends, currency trends, and other factors. Unfortunately we have all seen the effects of these factors over the last few years of the credit crunch. Once thought to be ‘risk free’, Sovereign risk has over recent times caused ripples of fear among investors.
There is no way that an investor can reduce the risk of securities themselves but diversify your portfolio to minimize risk and you will be better off.