What is risk diversification, and why is it so important for your investment portfolio?

The old saying “don’t put all your eggs in one basket” definitely applies to the world of investment, specifically in relation to what is known as risk diversification. This is an essential concept to understand if you want to create a balanced portfolio that will help you avoid the unpleasant surprises that market volatility can produce.

What is risk diversification?

Risk diversification is a strategy that involves investing in a variety of financial assets, so you can reduce your exposure to any one specific type of risk. The basic principle behind diversification is that by including a mix of asset types in your portfolio, rather than concentrating on just one, you can reduce the negative effects of market volatility or poor performance by one specific asset.

Diversification is so important because it’s based on the premise that different types of assets tend to react differently to the same economic, political, or financial events. By combining unrelated asset types, or even by looking for assets that will react in opposite ways, you can spread your risk more widely. Then, if one type of asset in your portfolio produces losses, the gains experienced by other types can offset them.

Of course, you still need to pay attention! Applying this concept to your portfolio doesn’t mean that you can be entirely free of losses, or eliminate the potential risk of experiencing them. What you can do, however, is make a better effort to protect your assets, by reducing exposure to risks that tend to affect individual asset types. The result is that you can decrease your chances of suffering significant losses overall.

Diversification can be applied in a variety of ways. For example, you can diversify the individual assets or asset types you invest in (such as stocks, bonds, alternative funds, etc.), or you can diversify at the geographical level, by adding international assets to your portfolio.

Why is diversification so essential?

If you’re still not convinced about the importance of diversification, the points below provide a summary of the main reasons why it’s important for any investor to maintain a diversified portfolio.

1. Reduce risk: This is not only the most obvious reason for diversification, it’s also the one that provides the most important benefit. Diversification can be your best friend when it comes to decreasing the risk associated with your portfolio. If one asset isn’t performing well, your other asset types can help compensate for any losses, minimizing the negative effects on your investments as a whole.
2. Optimize returns: Although diversifying your investments cannot guarantee high returns, it can help you achieve a more balanced risk-return ratio. When you invest in different types of assets, you can take advantage of opportunities for growth that may exist in particular industries, while still avoiding excessive risk.
3. Protect against volatility: Financial markets are volatile, and sometimes unpredictable. Diversifying your investments can help moderate market fluctuations, giving your portfolio a higher level of overall stability.
4. Mitigate specific risks: As mentioned above, investing in just one asset type or industry exposes your portfolio to specific risks, such as a particular company suddenly having financial problems, or regulatory changes that have a strong impact on a certain industry. Diversification distributes those risks more broadly, to protect your investment against specific unfavorable events.

How should you diversify your portfolio?

Diversifying your portfolio means distributing your investments among various types of assets, industries, geographical regions, and individual investments, to minimize risk and increase stability. Here are a few points you should keep in mind when making decisions about how to diversify your portfolio.

• Asset variety: Include different types of assets in your portfolio, such as stocks, bonds, real estate, mutual funds, and ETFs, because all of these asset types offer different levels of risk and return.
• Geographic diversification: Try not to restrict your investments to a single country or region. Investing in international markets can protect your portfolio against specific economic or political risks that affect a particular location.
• Industry diversification: This means investing in different economic sectors, such as technology, healthcare, consumer goods, energy, and finance. Remember, every industry reacts in its own way to the conditions that affect the market.
• Maturity diversification: This means investing in assets with a range of maturities. Include some short-term investments that can provide liquidity, as well as investments with longer terms that typically offer higher yields.
• Reassessment and adjustment: Diversification is not a “set it and forget it” type of strategy. You should periodically re-evaluate the contents of your portfolio and make adjustments when appropriate, to be sure that your investments remain in alignment with your financial goals and risk tolerance level. Assets with negative correlation: Within each asset type, try to select assets that have a low level of correlation with one other. This can help ensure that their values will tend to evolve in different ways when events occur and affect the market.
• Maintain a balanced portfolio: A balanced portfolio doesn’t have to include a huge number of investments. Simply by combining about 10 to 20 assets, you can achieve an adequate level of risk distribution.
• Consult with a financial expert: Last but not least, it’s never a bad idea to get in touch with a financial expert who can give you guidance and advice about the best way to create your diversified portfolio.