The key to reducing risk
Diversification is the principle of not putting all your eggs in one basket. In investment terms, it is a strategy to reduce the overall risk of a portfolio by investing in different asset classes (e.g. cash, bonds, shares, or property) that do not all move in the same way relative to the market.
Different asset classes display different levels of volatility/risk and offer different potential returns. For example, in the long-term investors can typically expect higher returns from equities (shares) than from other investments such as cash.
But higher returns tend to be more risky. In the case of equity investments, investors may run the risk of capital losses in the short-term. The returns from one period to the next may also be highly variable (volatile), which also contributes to the riskiness of equity investments.
In market downturns losses are offset by gains
Diversification works for the investor by combining riskier assets, which offer the possibility of a higher return, with lower risk, lower return assets. The result is a lower level of overall portfolio risk, and the potential for higher returns. In a market downturn, losses should be partially offset by gains recorded by other asset classes.
However, while diversification limits the potential losses suffered, it also means that the investor forgoes some of the exceptional returns which can be earned in the stock market.
Diversification can be achieved by building up your portfolio with your adviser's help from components such as bonds, money market funds, property and equity funds. Alternatively, you can choose a balanced type of portfolio in which the asset allocation is based on a predetermined mandate.
A well-diversified portfolio should enable you to meet your long-term investment objectives. But it is important to remember to view your investments as a whole and that every investor's solution will be unique.
Contact a professional financial adviser to help you structure and maintain a well-diversified portfolio tailored to meet your needs.