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A diversified portfolio can help reduce the risk of your investments suffering large falls. So how can you mix up your investments? And are there any drawbacks related to holding a diversified portfolio?
Keep on reading for all the details or click on a link to head straight to a section…
- What is a diversified portfolio?
- Why is it important?
- Why can you diversify your investments?
- Are there any drawbacks?
what is a diversified portfolio?
A diversified portfolio refers to having a mix of investments. For example, an investor who is well-diversified may hold a blend of stocks, bonds, commodities, property, and perhaps even cryptoassets.
Holding different asset classes isn’t the only way to diversify your investments, however. There are other ways that you can mix up your portfolio.
Investing in a mix of industries, rather than focusing on a single sector, is one way to reduce risks. Investing in stocks with different growth prospects is another. Spreading out your interests across multiple countries can also help to diversify your interests.
Let’s take a closer look at these methods to spread out risk:
1. Investing in different sectors
Holding stocks across a number of different sectors can be an effective way to diversify your portfolio. For example, you may wish to own stocks in a mix of industries, such as healthcare, energy, financial services etc, rather than focusing on a single sector.
2. Choosing stocks with mixed growth prospects
You can diversify your portfolio by holding bonds with contrasting prospects for growth. For example, an investor may choose to hold both value and growth stocks.
Value stocks are typically low-risk and have low volatility. Growth stocks, on the other hand, are more likely to be volatile. The flip-side is that they also potentially have greater a chance of delivering higher returns.
3. Investing across multiple countries
Holding investments in multiple countries can be another effective strategy for diversification. If you own international shares you won’t be overly dependent on the performance of a particular country.
This can be particularly useful if one country suffers from unexpected political turmoil!
why is it important to hold a diversified portfolio?
‘Don’t put all your eggs in one basket.’ It’s an adage that applies perfectly to investing. Putting your faith in a single asset class, sector, country, or type of stock is a risky strategy. For many investors, it’s probably unnecessary too.
The reason for this is pretty straightforward. If you invest solely in just one asset class, you risk suffering a big loss should that single asset perform poorly. In contrast, if you invest in multiple assets, the performance of your investments will be dependent on several asset classes, not just one.
In other words, a diversified portfolio should give you a good cushion should one, or a handful of your assets deliver a disappointing return.
a real-world example
If you were concerned about rising inflation last year, it’s possible you were tempted to buy gold. As we know, gold is one of the most precious of metals out there. Supply is finite too. These are two big reasons why many investors believe gold is one of the best inflation hedges.
This theory does makes sense, and gold has performed strongly during high inflation in the past. However, despite the obvious signs that inflation was rising last year gold actually fell 5.7% in 2021. In contrast, commodities such as oil and gas had a roaring year. Meanwhile, the FTSE 100 and FTSE 250 rose 14.3% and 14.6% respectively.
Any investor who put all of their faith in gold last year probably went on to rue that decision. In contrast, those holding gold as part of a mixed portfolio wouldn’t have felt the pain quite so much – especially considering the performance of other asset classes last year.
How can you diversify your investments?
Whether you’re looking to invest in stocks, bonds, commodities, property, cryptoassets, or a mix of all five, you’ll first need to find a suitable platform.
If you don’t want to buy stocks directly, eToro also offers a number of exchange-traded funds (ETFs). These allow you to have easy exposure to various alternative asset classes. Buying ETFs can be a decent option if you want some exposure to commodities, considering the real-world hassle that may be involved in holding physical assets.
Two examples of commodity-heavy ETFs include:
- iShares S&P GSCI Commodity‑Indexed Trust
- iShares Bloomberg Roll Select Commodity Strategy ETF.
On a similar note, if you want exposure to property, you don’t have to buy a house. Instead, may wish to consider investing in a Real Estate Investment Trust (REIT). eToro has its own RealEstateTrust Smart Portfolio which might be worth exploring.
Understand your appetite for risk
While it may be a wise move to hold a number of investments in your portfolio, you don’t have to split asset classes equally.
The way you allocate your portfolio should be heavily dependent on your appetite for risk. For example, if you’re nearing retirement, you may wish to hold more bonds than stocks. This is because a bond-heavy strategy is likely to reduce your overall exposure to volatility.
If you’re more of a gung-ho investor, however, then you may prefer to put more of your faith in the stock market.
For more information on investing within your risk profile, take a look at our article that explains how to create your own investing strategy.
are there any drawbacks to DIVERSIFICATION?
While we’ve discussed the potential benefits of having a diversified portfolio, there is a potential drawback to be aware of. Because diversified investors will have exposure to multiple asset classes, returns will rarely be extraordinary.
This is the price for reducing the risk of suffering large losses.
In contrast, however, an investor who puts everything on red and is successful, may enjoy dream returns. Yet this is undoubtedly a risky strategy as there’s a bigger risk of suffering heavy losses.
For most, a diversified portfolio with the goal of steady returns could be a far wiser way to invest, especially over the long-term.
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