Diversification is a smart investment tool for every investor thinking of growing wealth long-term and wanting to safeguard their investment portfolio from market instability.
In this write-up, we are delighted to discuss what portfolio diversification means and show you why it is important in the world of asset management. We also highlight some of the high-level risk management strategies to maximize the potential of an investment portfolio.
What is portfolio diversification and why is it important?
While some assets will have considerably higher risk than others, all types of investments have some form of inherent risk in them. The main function of portfolio diversification is to reduce total risk by carefully allocating investment capital to assets in different industries or categories. In the long run, portfolio returns in a well-diversified pool of investments are stable and more predictable.
In simpler words, one can view the premise and need for diversification from the old adage “do not pull all your eggs in one basket”. What it means is that one is likely to lose everything if they concentrate all their resources in one area and unseen losses occur. For instance, if an investor commits all their investment funds in the stock markets alone, they will lose it all when the market fails.
Risk of market failure is not limited to the stock markets alone, rather the whole financial market is at risk, including the property markets, commodities and international stock markets etc. Though it is highly improbable, it is not entirely far-fetched for all market segments to crash simultaneously and with the same magnitude.
Apart from capital injection to distinct financial markets, diversification helps utilize investment funds in different opportunities for a single asset class like real estate. Going back to our earlier example in the stock market, it is not enough to buy stocks in the petroleum industry only, it is best to acquire shares in separate and distinct industrial sectors.
Having covered the concept and value for portfolio diversification, the following section shows the strategies to use to diversify asset portfolios.
Quality trumps quantity
Albeit a few, it is better to have assets that properly complement each other, rather than have a litany of many investments pooled together without any strategic relationship. “Quality” assets may also refer to investment opportunities of high value such as public stock, or assets with high growth potential such as a startup that is experiencing rapid growth in sales. Many are investing in the UK right now as the outlook for UK dividends is encouraging.
Each portfolio may have distinct assets; additionally, capital allocation to each asset can also vary based on the investor’s risk appetite.
Add variety through alternative assets
Introducing alternative assets to a pool of conventional assets like equities, bonds or mutual funds is a ingenious way to diversify investment portfolio. Examples of alternative assets include real estate, private capital, venture capital and hedge funds.
Most alternative assets have a higher risk degree compared to the traditional assets, however, their price fluctuations are often inversely