Diversification is a crucial aspect of trading and investing that helps reduce risk and increase the likelihood of achieving long-term financial success. It involves spreading investments across different asset classes, industries, and geographical regions, rather than concentrating them in a single area.
Diversification enables investors to avoid the pitfalls of putting all their eggs in one basket and helps minimise the impact of adverse events that may occur in a particular market. A well-diversified portfolio can potentially generate more stable returns, protect capital, and create a better risk-award ratio for investors.
Thus, diversification is a fundamental strategy for achieving long-term financial goals for all investors regardless of their level of experience. But as with many things, this is easier said than done. So how do we put this into practice? Here are a few tips:
What is a well-diversified portfolio?
Nasdaq defines it as a portfolio that includes a variety of securities so that the weight of any security is small. The risk of a well-diversified portfolio closely approximates the systematic risk of the overall market, and the unsystematic risk of each security has been diversified out of the portfolio.
This means that a diversified portfolio should not be a list of assets picked randomly. It is not enough to simply pick and choose any investments. A well-diversified portfolio should typically include a variety of securities to help reduce individual security risks and align to the systematic risk posed by the overall market.
In short, building a well-diversified portfolio starts with choosing your investments across a broad mix of asset classes, so that the risks come at different scales and intervals depending on the chosen assets. To take advantage of the benefits of diversification, aim for a variety of asset classes:
- Stocks, also known as equities; allow you to have partial ownership of a company
- Bonds, also known as fixed-income securities or debt instruments: where you lend money to a company or government in exchange for regular interest payments
- Alternative investments: Those that have a lower correlation to the stock market (real estate, commodities, hedge funds, crypto)
When your investments have a low correlation to each other, a healthy level of diversification will result in one asset’s poor performance being compensated by the stronger performance of a another one, thus potentially reducing overall risk over time.
How you split your investments between assets is called asset allocation. Your allocation should be based on factors like your financial goals, time horizon and risk tolerance. Investors with a high appetite for risk and/or a longer time to stay invested can benefit from a more aggressive asset allocation.
Consider investing in an ETF
Should you be short on time to research individual stocks, you might consider adding passively managed funds to your portfolio, like exchange-traded funds (ETFs). An ETF provides a basket of securities that can help do the diversification job for you, especially if you combine several ETFs that are not correlated to each other. There are many types of ETFs that cover equities, bonds, commodities and even currencies. Adding even a single ETF to your portfolio can significantly diversify your portfolio. ETFs also tend to have lower fees compared to mutual funds.
Regularly rebalance your portfolio
Investing is an ongoing process that requires intentional adjustments over time. Once you have your ideal asset mix, commit to maintaining it with regular check-ups and rebalancing. Over time, the weighting of each asset class will change based on the return of your investments. This alters the risk profile of your portfolio, making rebalancing an important part of managing your investments.
It is helpful to periodically compare where you started with where you are now, and determine whether the performance aligns with your long term goals. Once that’s done, you should make sure your exposure to certain asset classes is within the risk levels you had envisioned. If not, rebalance any asset that has drifted away from your desired asset allocation. Here are a few portfolio examples illustrating various asset mixes depending on different goals and time horizons:
- Conservative portfolio: 20 percent stocks, 50 percent bonds, 30 percent short-term investments.
- Balanced portfolio: 50 percent stocks, 40 percent bonds, 10 percent short-term investments.
- Growth portfolio: 70 percent stocks, 25 percent bonds 5 percent short-term investments.
Investing puts your money to work for you, helping you build wealth over time and reducing the impact of inflation. The earlier you start, the longer you can have the power of compounding help you reach your goals. More importantly, building a diversified portfolio will cultivate financial discipline, a habit of saving, and a deeper understanding of investment instruments.
Regional advantage
The recent success of IPOs in the Dubai Financial Market and Abu Dhabi Exchange Securities has brought to fore a wide choice of MENA-based financial instruments for investors to choose from. These include listed equities, derivatives, ETFs, and Bonds. Today, novice investors in the UAE can choose from multiple providers to begin their journey.
To sum up, diversification is a crucial aspect of trading that should not be overlooked. It involves spreading investments across different asset classes, sectors, and markets, to minimise risk and increase the potential for long-term gains.
By diversifying, traders can protect their portfolios from market volatility and reduce their exposure to any one particular investment, nevertheless, investors need to keep building their knowledge of the many instruments available and choose ones that help support their goals.