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Why is portfolio Diversification Essential?

The world’s financial markets have undergone a unique period of volatility through 2020 and the formative months of this year, with global stocks offering a relevant case in point.

Currently, Warren Buffet’s global market indicator is sitting at a troubling 142%, having peaked at 205% just a couple of weeks before. This measures the share price of firms against national GDP, with the current reading indicative of an overpriced market that could be on the precipice of crashing. 

With this in mind, diversification is crucial when looking to create a profitable investment portfolio. But what does this mean and how can you go about achieving such an objective?

What is Portfolio Diversification?

In simple terms, a diversified portfolio describes a collection of different investments that combine to reduce your overall risk and exposure as an investor.

If you trade stocks, for example, you should strive to leverage assets from several different industries and countries, while also tapping into variable market caps and companies that boast diverse risk profiles. 

You should also augment this with practices such as forex trading, while also considering other investments like fixed-income bonds, commodities and even real estate.

Recommended Read: Everything you need to know about bonds

But why is this so important? Well, with the right combination of assets (which treads the fine line between being overly exposed and over-diversifying your portfolio) you can actively reduce your risk of permanent capital loss as an investor, while minimising overall volatility in the process.

Without this, it can be hard to attain sustainable and consistent profits as an investor, particularly during periods of change, uncertainty or peak volatility in specific markets.

How to Diversify Your Portfolio?

The next step is to understand the best practice for portfolio diversification, including a number of different tips that can afford you an advantage regardless of the prevailing market conditions. For example:

  • Diversify Within Different Types of Investment: As we’ve already touched on, it isn’t always enough to trade different assets. Additionally, you should also aim to diversify within individual investment types, with stocks offering a relevant case in point. Be sure to combine stocks with mixed-income, growth and market cap values, for example, while also trading targeted indices that automatically target a large number of viable assets.
  • Target Assets With Different Rates of Return: Through the process of diversification, you can also look to target assets that offer variable rates of return. There’s certainly some sound logic behind this practice, as this ensures substantial gains for some investments and can help to offset losses in alternative markets. When used alongside other types of diversification, this can prove highly effective over an extended period of time.
  • Don’t Over-Diversify: As we’ve already said, you need to be patient and strike a balance when diversifying, which is why it’s better to scale your efforts organically over time and in line with growing profits. There’s certainly a danger of over-diversifying, as this can significantly weaken your returns and leave your capital spread too thinly within the marketplace. So, aim to hold between 15 and 20 stocks in your portfolio at any given time, even as you chop and change the assets included.

Recommended Read: Where to invest?