As an investor, whether new or seasoned, a governing principle to be mindful of is that there is a degree of risk inherent in investing. This makes diversifying your investment choices important. Risk refers to the degree of uncertainty and/or potential financial loss inherent in an investment decision. It stems from economic and financial market changes, the length of your investment time horizon, among other factors, can influence the value of the funds invested over time. However, this risk can be mitigated or managed by the same principle governing the adage “Don’t put your eggs in one basket”. This is at the core of having a diversified portfolio, which is simply a collection of different investments that, combined, seeks to reduce an investor’s overall risk exposure, while giving them the best chance to maximise returns. Let’s do a deep dive into what this means.

Diversification across asset classes

A diversified portfolio has a combination of different types of assets across varying industries, regions, and other categories. Each type of asset reacts differently to similar events, reducing your exposure to any single risk. This helps to limit or mitigate any potential loss that could be suffered. The idea is that if one of your investments performs poorly, it will have a smaller impact on your overall portfolio if you have other investments that are performing well. This therefore simultaneously helps you to maximise your potential returns by putting you in a position where the whole becomes more valuable than the sum of its parts. How you decide to spread/diversify your investments will depend on your risk profile (that is your ability and willingness to take risks), your investment goal, and the amount of money you have available for investing.

Let’s look at the most popular asset classes across which you can diversify your portfolio.

Stocks: A stock represents a share of ownership in a company. These are risky assets because they offer no guaranteed returns to investors. However, because of the high risk they are expected to generate higher returns to compensate investors. In fact, they have proven to provide the best historical average return over longer time periods. Their prices tend to be more volatile in the short term, but become less volatile in the long term as the market recovers from economic and financial events and conditions. The key to success is investing in companies that align with your investment strategy and profile, investing in the long term, and investing the time to understand the fundaments of the market and the companies which you invest in, or have a desire to invest in.

Bonds: A bond is an IOU from an entity (government or private) to investors. This comes with a promise to pay back the amount at a specific time, and with a specific interest rate that compensates the lender for parting with his/her money for that period of time. As a result, bonds tend to be less risky because of this promise. However, investments in bonds generally require a higher amount to be invested as the initial principal.

Unit trusts: Unit trusts have been around for quite some time and have inherent diversification benefits. They are what I would like to call self-contained investment portfolios that allow investors to share in a basket of assets grouped according to pre-defined characteristics. Your money is pooled together with other investors’ and a fund manager invests this on your behalf across different assets. This gives you access to multiple securities, even costly ones such as bonds, for a fraction of the cost. Since the funds are spread across multiple assets, this reduces your risk exposure.

Real estate: Investing in real estate continues to be a recommended asset class as its value continues to increase overtime, and it can provide some investors with a stable income through rent collected. Traditionally, the barrier to investing in real estate would be the initial cash required to purchase property. Thankfully, this has been changing as financial and other institutions have increasingly been offering real estate-backed investment products that allow investors to reap the benefits of the asset class without the significant outlay typically required. Such products include real estate investment trusts (REITs), real estate funds, etc.

Diversification within asset classes

Diversification should not be limited to different asset types. For true diversification, you should also reduce the risks within each asset class. For example, when it comes to stocks you can diversify by the size of the companies (large-, medium-, or small-cap stocks), by geography (domestic or international), as well as by industry and sector. You could even choose to invest in a unit trust that is based on a diversified set of stocks. The possibilities truly are endless.

At the end of the day, your diversification strategy should be tailored to your personal financial goals, as well as your willingness and ability to take risks. Though risk is inevitable and cannot completely be eliminated, you can mitigate those inherent in investing, including in a declining market, by taking positions in a broad mix of investment opportunities. If you need help customising a plan, speak to a trusted wealth management professional to see the kind of diversified portfolio that is best suited for you and your financial goals.