The importance of diversification

The fear of losing money is probably the number one reason why many people choose not to invest. Yet there is a way that the risk of losing money could be reduced by putting your money into different investments, rather than putting all your money in one place. This is what is known as ‘diversification’.

What is diversification?

Diversification simply means not putting all of your investment eggs in one basket. The idea is to spread your risk exposure by investing across different asset classes.

This means that investments that perform well in a diversified portfolio will likely balance or outweigh other investments that may not be performing as well. This could provide a degree of protection against major losses to your money and investments.

What is an asset class?

An asset class is a group of investments that share similar characteristics. For example, they may respond to market ups and downs in a similar manner and share comparable potential for risk and growth.

The four main asset classes are:

• Stocks (also known as equities) which are shares in a company.

• Cash is the money you have in the bank.

• Fixed income is an investment which provides a steady income flow such as bonds that pay a fixed rate of return in the form of interest.

• Real estate and commodities come in the form of a tangible asset like property or precious metals.

These asset classes can be split into many more sub-classes based on factors such as location, size, and industry.

The benefits of diversification

This table demonstrates the key benefit of diversification. It shows how different asset classes have performed over a number of years in percentage terms. You’ll see that no single asset class consistently comes out on top. This highlights how difficult it is to forecast which asset class will perform best in the future.

Source: Bloomberg, 30 December 2022

This is why, at Schroders Personal Wealth, we believe that by holding a range of investments, you are not exposed to one single type of asset therefore your investment risk is reduced.

The mix of assets that are appropriate to you will depend on your individual circumstances and your financial goals. A good financial adviser can offer insights into which blend of investments could potentially be right for you based on your financial planning needs.

Lower your overall risks

When the economy is growing, stocks tend to perform better than bonds. But when things slow down, bonds tend to outperform stocks. By holding both stocks and bonds within your portfolio, you reduce the chances of your portfolio being heavily impacted when markets fluctuate. This is because different assets should be rising and falling at different times, therefore smoothing out the potential returns of the portfolio as a whole.

So, in summary, the main advantage of diversification is that it lowers your overall risk. It’s a risk management strategy to help safeguard you from major loss; if one of the investments you have falls sharply, it won’t damage your entire portfolio.

Investing can be unpredictable, but by spreading your money you can be prepared for volatility in the market. With good financial advice, the benefits of diversification have the potential to pay off in the long run.