Richard Draper
March 16, 2021

What is Investment Portfolio Diversification?


There is a lot of financial jargon used all the time, that can make investing daunting. One term you may have heard of is ‘portfolio diversification’. Any banker, financial planner or wealth manager will always tell their clients to ‘diversify’ their investment portfolio. That is great advice, but what does this actually mean and how can you diversify your investments? 


Investment diversification definition

 

In its simplest form, investment diversification is the same as saying ‘don’t put all your eggs in one basket’. If you purchase just one investment and it performs badly, you risk losing all of your money. By adding other investments, you reduce the risk of this happening and hopefully the profits from your other investments will offset the loss on the bad one. 


Therefore, by spreading or ‘diversifying’ your investments across lots of different investment products, such as stocks, bonds and alternatives, as well as different industries and countries, you can lower your overall risk without sacrificing long-term returns.



Main reasons to diversify your investment portfolio


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Concentration risk


As with any type of investing, there are various different types of ‘risk’. The main risk we are referring to when talking about diversification is ‘concentration risk’. This is the risk of investing in just one investment or one type of investment. For example, you may own 10 different stocks and consider yourself diversified, but if they are all very similar, or ‘correlated’, then you are not. 


The risk here is that something unexpected happens that impacts all those ‘similar’ investments at the same time. You will have nothing in the portfolio to protect yourself from a fall in value. It is unrealistic to think all risk can be removed from an investment, however, a diversified portfolio will help reduce concentration risk in a number of ways.



Correlation


As we have seen in the example above, just adding more investments that have very similar characteristics won’t necessarily help you diversify. The relationship between assets can be called their ‘correlation’. Essentially, this just refers to how they move in relation to one another. For example if two investments both go up in value at the same time, they are likely positively correlated, if one goes up when the other goes down, they are negatively correlated, and if they don’t have any pattern then they most likely have a low correlation or no correlation at all. By adding assets that are less correlated or negatively correlated, when one goes down the others can help stabilise the portfolio by either remaining steady or going up.


Should you diversify your investment portfolio?


The simple answer is, yes. 


Stories of investors ‘getting rich’ owning only one or two stocks sound great, however, you don’t hear that many stories where the same has happened in reverse, with the investment losing 90%+ of its value. It’s impossible to accurately predict which investments will go up or down in value, especially in the short-term. That’s why diversification is so important. It helps protect you from losing money, whilst maximising your chances of making money over a longer period of time. 


Whilst all investments carry risk, experts will all agree that diversification is one of the most important investing concepts to help you achieve your long-term financial goals.  


How to diversify your portfolio?


We have established that diversification is important and that it isn’t as simple as just adding more of the same type of investment. So how should you go about diversifying? The first step is to assess what you currently have. Do you, for example, have 100% of your money in cash or perhaps all of it in cryptocurrency? If this is the case, you are certainly not diversified. 


You should look to diversify across the three categories below:


One of easiest ways of quickly and easily diversifying a portfolio is by purchasing mutual funds or exchange traded funds (ETFs). They offer you a simple way of gaining a vast amount of exposure very cheaply across all three categories above. 



Diversification options for retail vs. professional investors 


Until recently, the options available to everyday investors like you and I have been fairly limited to stocks, bonds and real estate. Wealthy investors have for a number of years allocated a portion of their portfolios to a specific type of alternative investment called ‘collectibles’, like those offered by Koia. They have unique characteristics and are often uncorrelated to more traditional investments, which helps to protect and grow wealth over time. For the first time, Koia makes it easier for all investors, not just the wealthy, to diversify their portfolio with collectible assets. 



Conclusion


Diversification can help investors not only manage risk and volatility, but also give you access to a wider range of investment returns. Diversification can't remove all the risks associated with any type of investing, but it will help smooth out your returns and enable you to focus on long-term wealth creation through economic cycles. Adding low or negatively correlated assets, such as alternative investments, can dramatically improve the risk / return profile of your portfolio.

At Koia, we allow you to start investing in tangible assets for as little as €50, via fractional investing. Our experts make sure to source and buy the best assets, and we take care of authentication, storage and insurance. All of the benefits, with none of the hassle.

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The articles and information made available on Koia are provided for information and educational purposes only and do not constitute financial advice. You are advised to consult with an independent financial advisor for advice on your specific circumstances.