Chapter 6 – Why is diversification important?
The philosophy behind portfolio diversification is that if one investment performs poorly, you will always have others that will, ideally, not be performing badly at the same time. This allows your varied investments to act as counterbalance to one another. The “asset allocation” or in other words, how you divide your money between shares, cash, fixed-interest securities, foreign exchange, digital currencies or property is crucial. A common mistake investors make is in not diversifying enough. As a result, some investors have been burnt badly by having all their eggs in one basket, or their investments in the same asset classes. Diversification is indeed the key to managing risk – including volatility.
Market risk cannot be avoided. For example, if the whole global economy and international markets crash, then more or less every asset class will suffer. And this is where an adviser can step in and help you determine the level of risk, you’re comfortable taking on. To make sure a portfolio is spread across asset classes, it might contain a blend of several different asset classes such as equities, bonds, cash, foreign exchange, digital currencies, property and others, such as commodities and gold, to benefit from their different investment cycles.
Many fund portfolios contain the same classes, which means you are not as diversified as you might think you are when investing in funds. It’s important to see and analyze fund strategies within sectors in order to have a diversified portfolio with placements in several areas/sectors.
It is far better to have a wider spread of holdings and therefore a wider spread of risk by allocating into several different types of assets, sectors and countries of interest.