In times of stock market turmoil, it is easy to be tempted into making unwise investment decisions – with potentially devastating consequences. The antidote is a proper fundamental approach to your portfolio – one that ensures you have both the mental and practical resilience to wait out a potential stock market downturn and come out the other side strong.
Having a diversified portfolio allows you to capture more assets that are performing well. At the same time, it is a good and important hedge against future market falls. The oft-repeated investment advice from prominent economists and various private advisors tends to be: “diversify more, do not put all your eggs in one basket”.
What is diversification?
Understanding how diversification works require an understanding of the concept of correlation, and how it is defined in the context of investments.
Correlation is a statistical measure of the performance of assets in relation to each other. If the correlation between two assets is positive, it means that their value is moving in the same direction; if it is negative, the opposite is true; and if the correlation is zero, there is no relationship at all between how their prices move.
With this knowledge of the correlation of several assets, diversification can be achieved. Diversification, or risk spreading as it is also called, is an effective way to manage risks on the market. Diversification aims to reduce the risk that the portfolio will lose a lot of value when individual investments lose value.
So, how do you diversify your investment portfolio in the best way possible?
Spread your risk with more securities
Multi-asset diversification is the process of spreading your risk across multiple assets, such as various stocks, funds, and/or other securities. All investments come with some type of risk and no matter how safe you feel, unforeseen things can happen.
If you invest all your money in one company because they are world-leading right now, you will lose it all if they go bankrupt. Therefore, you should not put all your eggs in one basket, as the saying goes. Instead, you would have been better off spreading the risks over several securities and companies.
Let us say that in addition to shares, you also invested in various commodities, government bonds, fixed income securities, and mutual funds. Then you would have spread your risk with more securities, which would make your portfolio more diversified.
Spread your risk across multiple markets
Another good way of diversifying your investment portfolio is to spread your risk across different markets. You will not have spread your risk significantly if all your chosen securities have exposure to a single country and the same sector. For better risk diversification, you should invest in securities oriented towards different sectors in several different countries.
Let us say that you invest in US tech companies, German fashion chains, and the French health system. This means that you spread your risks across different markets and countries, making your portfolio more diversified.
Diversify over time
Last but not least, you should remember to diversify over time, such as in a monthly savings account. Regular purchases have several advantages as you buy in both up and down periods, which provides better performance of the portfolio.
The negative consequence of buying at the top is, in other words, counteracted by regular buying at the bottom. With this, you avoid trying to time the market at all times. This further reduces the risk of losing a large part of your capital on the day you wish to withdraw your earned yield.
Sign up with a broker that allows a broad exposure
Online brokerage is an internet service that allows investors to trade shares and other securities directly, without having to turn to a physical bank. An online broker may offer trading on one or more exchanges and most commonly, these brokers offer trading on a wide range of exchanges in different countries. Having said that, you should turn to an online broker that allows you to get a large exposure to the investment market and spread your risks in the best possible way.
Knowing which is the best online broker can seem like an impossible task, especially for a beginner. We recommend that you compare different online brokers to find one that suits you in terms of an array of securities and markets, but also ease of use, fees, and customer support.
We can recommend Olymp Trade, which is a fully regulated and legal trading platform. An online broker with a user-friendly interface, plenty of investment opportunities in different markets, low fees, and professional customer service. You can read more about the online broker here: https://www.trusted-broker-reviews.com/olymp-trade/.
Summary
Diversification is a key concept within investments, and it aims to lower the risk of capital loss by spreading one’s risk across multiple securities and markets. In this way, diversification goes hand in hand with the concept of margin of safety.
Diversification can be said to act as a kind of insurance against mispricing or simply against the fact that some companies that are successful today may perform negatively in the future.
However, it is not that simple. A diversification that is too narrow can increase the risk of loss of capital, and diversification that is too broad can increase the risk of underperformance of the invested capital.
Therefore, a well-formulated diversification strategy should be a cornerstone of any investor’s investment strategy. Below are some examples of what a good diversification strategy could look like:
- In terms of shares, you should own more than 12 different shares, preferably spread over several markets.
- You should continue to regularly increase your holdings over time, preferably every month.
- In terms of funds, you should own seven different ones, again preferably in several different markets.
- You should continue to save on an ongoing basis, which is easiest to achieve through monthly savings.
- Your portfolio may include other securities as well, such as real estate, commodities, currencies, and cryptocurrencies. However, do not let this take up too much of your portfolio.
