Diversification: What it is And Why it is Crucial in Investments

There are old sayings that are never wrong. For example, “Don’t put all your eggs in one basket” can be a useful guideline for those who want to invest.

In fact, if something happens to the egg basket, you lose everything and, even if you are not a farmer, this bit of wisdom could be very useful and prevent you from risking all your money in one single investment.

In practice, for an investor, this old saying means to diversify the portfolio to mitigate the risk related to the market volatility. That’s why it’s important to comprehend the benefits of diversification in the financial sector, in particular for first-time investors.

As previously stated, diversification allows to reduce risk by allocating money across different financial products and areas. In this way, the investor might be able to minimize potential losses, since each area of investment reacts differently to the same event. Thus, to obtain a diversified portfolio, it’s important to mix different investments which aren’t related to each other. But how it is possible to achieve this result and create a solid portfolio?

Divide your investment

The first thing to know about portfolio diversification, it is the possibility to spread your money among different kinds of financial vehicles. For example, many people decide to invest tax wrappers, such as SIPPs or ISAs. For the latter, you should know that there are many types of Individual Savings Accounts, which serve diverse purposes and allow you to save or invest in different assets, such as stocks, bonds, etc. You can have as many ISAs as you want, but you can only open one type of ISA variant per tax year. And how many ISAs can you pay into in a year? Similarly to the number of each variant you can open in a year, you can only pay into one type of ISA variant in the same tax year. However, you’ll still be able to contribute to the other ISAs variants, but the total sum must not exceed the annual allowance, which is £20,000 for the current tax year (2022/2023).

According to your preferences, needs and risk tolerance, you might consider to invest in an array of assets, by mixing different financial areas which appear to complement one another. For example, many investors choose alternative investments, such as real estate, private equities and commodities. Regardless of the type of financial product, it is recommended not to invest all the money in a single stock, funds or industry. Maybe, another way to mitigate the risk could be to invest in a few companies or in financial funds you are familiar with.

Use the dollar cost averaging

This passive investment strategy might also help investors to diversify their investments. The technique involves to invest the same amount of money in securities at regular intervals over a certain period of time, regardless of the prices. Thus, this strategy may allow the investor to lower the average cost per share and reduce the impact of market volatility. As a matter of fact, deletes the effort usually required to time the market to buy the shares at the best prices.

Choose the assets according to your portfolio and risk tolerance

A diversified portfolio according to your needs should be balanced. That means it’s critical to regularly review your financial portfolio: in addition to monitoring the growth of your investments, you should verify that all of your assets are according to your objectives and life achievements. If you are not an expert in this field, you should consider to seek the help of a financial advisor.

It should not be understated that certain factors, such as attitude toward risk, should also be taken into consideration when it comes to arranging your investments. Perhaps some people are more willing to take risks, and this also could depend on their family background and economic situation, of course. Factors such as liquidity, industry and market trends should also be taken into consideration.

Anyway, study and experience could help you to sharpen your intuition in choosing which investments may be proper for your portfolio.