The Basics of Diversifying Investments

Investing is a powerful tool for growing your balance over the long-term, but it comes with its fair share of risks. One key strategy to balance risk and reward in your investment portfolio is diversification.

What is diversification you ask? Simply put, investment diversification means spreading your money across different investments. The underlying principle is simple: "Don't put all your eggs in one basket." By spreading your money across a range of investments, you can potentially lower the overall risk and ups and downs in your investment portfolio while aiming for more stable returns over the long-term.

Here, we’ll look at an easy-to-understand example of diversification, why you should consider diversifying your investments and ways to do it.

Example of diversification

Imagine you have a big garden where you grow different types of fruits, like apples, oranges, and strawberries. Each fruit is like a different investment.

Now, let's say you really love apples, and you decide to plant only apple trees in your garden. If something bad happens, like a disease that affects apple trees, all your fruits (your investments) might be in danger, and you could lose them all. But if you have a garden with a mix of apple trees, orange trees, and strawberry plants, you're less likely to lose all your fruits if something bad happens to one type.

In the world of investing, this is similar to diversification. Instead of putting all your money into just one type of investment, like only buying shares in one company, you spread your money out into different types of investments, like shares, bonds, managed funds, exchange-traded funds (ETFs), and property. 

Why should I diversify my investments?

No one can predict how the market will perform at any given moment, but what we do know is that markets go through cycles of ups and downs. That’s why diversifying your investments is the smart way to approach your financial planning and risk management.

The primary benefit of spreading your money across different investments is your risk is reduced. A diversified portfolio is less vulnerable to severe losses because not all investments will react in the same way to market ups and downs.

Diversification can potentially lead to more consistent returns over the long term. While it may not outperform a portfolio with just a few investments when the share market is doing really well, it's usually better at keeping your money safe when the share market is not doing so well.

Peace of mind is important to any investor. Knowing that your investments are spread out can reduce stress and anxiety associated with market ups and downs (known as market volatility). This can lead to better decision-making and sticking to your long-term financial plan.

Ways to diversify your investment portfolio

1. One of the most common ways to diversify is by investing in different asset classes. This might include shares, bonds, funds, and property. Each asset class has its own risk and return profile, and they can often react differently to market conditions.

2. When determining the right mix of asset classes that align with your financial goals and risk tolerance, consider investing in managed funds or ETFs. These types of investments inherently offer diversification since they pool investors' money to invest in a wide range of assets.

3. Location, location, location. Investing in different markets around the world is a good way to diversify your investments and can also reduce risk. For example, if you hold shares in both the United States and Europe, a downturn in one market may not have as severe an impact on your investment portfolio.

4. Within the share market, spreading your investments across different industry sectors can be beneficial. If you only own shares in technology companies, consider balancing your portfolio with investments in healthcare, energy, or consumer goods.

It’s a good idea to review your investments every now and then to ensure they remain aligned with your goals, timeframes, and the level of risk you’re comfortable with. 

Investment diversification is a fundamental strategy that can balance risk and reward in your portfolio. By spreading your investments across various assets, you can reduce risk, potentially enhance returns, and increase your peace of mind. Whether you're a seasoned investor or just starting out, diversification should be a key part of your investment strategy. Remember, it's not about avoiding risk entirely but managing it wisely to achieve your financial goals.