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For many people, managing risk is an important part of investing. You can do this by spreading your money across different types of investments. This approach is called diversification.
What is diversification?
Put simply, it's when you spread your money across different types of investments to help manage investment risk. Think of it like a farmer planting different crops to both reduce the risk that one crop fails and spoils an entire harvest, as well as increasing the chances of a good overall yield.
With diversification, you're less reliant on the performance of any one of your investments. So, if one performs poorly, another type of investment you hold could help balance these losses and potentially reduce the impact. This can help make your investments more resilient to market fluctuations and unforeseen events.
How to diversify your investments?
Spreading your money across different investments is at the core of diversification, but there are several ways you can do this. Here are some of the options.
Across investment types
This involves putting your money into several different types of investments, such as shares (sometimes called 'equities'), bonds (loans to countries and companies), commercial property and specialist areas like commodities (gold, oil or wheat).
What drives these investments to rise or fall in value is very different. For example, what affects the performance of commercial property is likely to differ from what influences stock markets where shares are bought and sold.
Many investment types tend to perform independently of each other in different market conditions and at various points during the economic cycle. In investment speak, that’s called ‘low correlation’ – they don’t share a close relationship and so behave differently.
Across geographies
You can also diversify geographically by investing across different regions, countries and continents. This reduces the reliance on the performance of any single market.
For example, you could choose to invest mainly in UK shares but also include some exposure to European and US company shares.
Across sectors
Similarly, investing across various sectors or industries, such as technology, healthcare or finance, can also help reduce the risk associated with the performance of any single sector.
To diversify your investments even further, you can invest across company sizes too. This involves investing in a mixture of large and small companies (known in the industry as large-cap and small-cap companies, based on each company’s valuation).
Balancing risk with reward
It’s important to understand that diversification can’t eliminate all risks. The value of all investments can go down as well as up, so you must be prepared that you may get back less than you invested.
And there may be times, for example during extreme uncertainty in financial markets, that even seemingly diverse investments perform more similarly than expected. That could see them all fall in value at once.
Diversifying too much can also limit potential gains. Strong performance from one investment may be diluted by weaker performance from others, pulling down your overall return.
All investors must balance how much risk they’re prepared to take in return for potential rewards. Generally speaking, taking more risk gives the potential for higher long-term returns. To better understand how much risk you’re comfortable taking – your attitude to risk – our risk profiler can help.