What is portfolio diversification?

Most of you will have heard someone say “Make sure to always diversify within your portfolio!”, but what does this actually mean? Portfolio diversification has been a hot topic in the world of investing for decades, largely because it’s associated with greater financial security and the promise of higher net returns overall. That is not to say that you are guaranteed an impressive net return just by portfolio diversification alone, you need to ensure that you have a specific strategy or goal in mind which you can then use to determine how you are going to distribute your investments. Portfolio diversification can describe the allocation of your investments within a single asset class (where low to high-risk variations exist) or multiple asset classes.

Investopedia describes diversification as:

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

While the claim of the ‘high yield, low risk’ which can be achieved through portfolio diversification is valid, remember this, if you try to do this yourself with no research or background knowledge on the subject then it is likely that you will experience the opposite of high yield and low risk. For example, splitting your total portfolio evenly across Bitcoin, Ethereum, Ripple and Litecoin is not a diversified portfolio. Not only are they all members of the same asset class (Cryptocurrencies, in case you were asleep in 2017), their performance is highly correlated, meaning if a new regulation is enforced to the detriment of Cryptocurrencies then your whole portfolio is at a high risk of loss.

Step 1 – Determine your goals

First, you should ask yourself the following questions and take some time to answer them honestly. The more specific you can be at this stage, the more confident you can be that you will achieve these goals within a given time period.

  1. How long do you plan to invest for and do you need immediate access to your funds?
  2. Do you want to generate a monthly cash flow almost immediately or leave your funds to accumulate over time?
  3. What goal are you investing for?

Arguably, point 3 is the most important question. Whether you are saving for retirement, your children, travel or even an extra source of income, agreeing a pre-defined goal with yourself before you begin will not only give you motivation to make this become a reality, but also to allow you to track your progress in the meantime.

Step 2 – Choose an asset class

An asset class is something that contains a similar group of financial instruments (i.e. things that can be traded) with some kind of monetary value. There are several different types of asset classes, the main ones being equities, cash, bonds, real estate and gold. Real estate, for example, may be considered as much higher risk than bonds.

In the modern day, investing is significantly easier than in the past. You no longer need a financial advisor to help you invest, in fact many people actively choose against it to save on the colossal management fees that eat into your annual net return. Now that the same information is available to everyone, investors with no financial experience or education can earn returns that match or surpass those earned by the world’s best fund managers. How? Automated investing, now possible thanks to advanced and reliable technology.

While choosing an asset class can sound difficult at first, with a little research you will find there are a number of fantastic platforms with specialisms in these different assets offering their services to the individual investor. You no longer have to be an institution or wealthy individual to take part.

Step 3 – Diversify

Once you complete step 1 and 2, think realistically again if you will need to access to your money at short notice. If yes, you may want to avoid illiquid investments like real estate. On the other hand, real estate can be a fantastic investment if you know you will not need your funds any time soon and you want to generate a monthly cash flow.

Investing in Peer to Peer lending combines the positives of near-instant access to your funds (dependent on the investment method you select), generating a monthly cash flow and still being able to benefit from the effect of compounding interest for those investing with a long-term horizon. Within P2P itself, you can achieve a high level of diversification by choosing to invest in loans with a range of credit ratings (low to high risk), countries and durations. Invest with Bondora today.

Diversify and conquer!