How to diversify your investments

The key to generating consistent returns from your investment portfolio is diversification. This helpful guide explains what diversification is and how to do it.
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Updated: Sep 15, 2022
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One of the top priorities of anyone looking to build a profitable portfolio of investments is diversification. On this page, we have broken down the process of diversification into easy-to-follow steps and explained all of the things you need to consider. Read on to learn more about the investments world.

What is diversification?

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Diversification is a form of risk management; it is the practice of combining a wide variety of investments into one varied portfolio. This includes different countries and investment types, such as stocks and cryptocurrency. A common way of referring to the process of diversifying a portfolio is ‘hedging’. 

Why should I diversify my portfolio?

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In short, it avoids all of your eggs being put into one basket. Individual investments can go up or down, and if you were to invest solely into a single asset, any decline in its value would have a heavy impact on your finances. 

However, by spreading the risk out over multiple asset types and jurisdictions, your portfolio becomes balanced, meaning that when certain investments perform poorly, other investments within the same portfolio can help to compensate. 

This limits the risk that your capital faces, and can insulate you from adverse market reactions caused by things like geopolitics, economics, interest rates, conflicts, health crises and even natural disasters. 

In the long term, diversified portfolios tend to provide a greater, more consistent return on investment (ROI), and this is why diversification is a strategy practised by all of the world’s major financial institutions. 

How to build a diversified portfolio – a step-by-step guide

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To help kickstart your diversification process, we have broken it down into three easy-to-follow steps. Read on to get started. 

Step 1: Diversify by asset type

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The first step to successfully diversifying your portfolio is ensuring you have a wide range of different investment types. Here is a list of the different asset classes that are available to you:

  • Stocks. This is a portion of ownership in a publicly traded company.
  • Cryptocurrency. A popular asset for modern investors, cryptocurrencies are essentially digital money that use blockchain technology. 
  • Bonds. This is when you effectively loan money to a company for returns. 
  • Real estate. You can invest in a wide range of real estate including land, buildings, natural resources, agriculture, livestock, and water and mineral deposits.
  • Exchange-traded funds (ETFs). These are a tradeable group of stocks that are designed to track an index, commodity or sector.
  • Commodities. The two most popular commodities to invest in are crude oil and gold. 

Compiling a selection of these different asset types is the first step to building a diversified portfolio. Each type has different characteristics and catalysts that affect its performance, along with a specific risk profile.  

For example, stocks typically decline in uncertain economic times, while safe-haven assets like gold, real estate and some cryptocurrencies – such as Bitcoin – may rally. 

Within each type, there is even more room for diversification. For example, some stocks – such as dividend stocks – will provide stable returns with low risk, while others – such as growth stocks – provide the potential for huge returns with a much greater risk. 

Step 2: Diversify by location

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Diversifying by location is critical if you want your investment portfolio to be properly insulated from geopolitical events. Foreign diversification ensures that unexpected negative outcomes in specific countries don’t affect your entire portfolio. 

As a rule of thumb, having at least 80% of your portfolio situated in safe jurisdictions with strong economies, infrastructure and national security is a good idea. The remaining 20% can be allocated to assets located in countries with a greater degree of risk. 

Step 3: Diversify by long term and short term

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Some asset classes are likely to perform well tomorrow, while others will take a few years before they deliver serious returns. Therefore, it is recommended that you take a hands-on approach with your portfolio and combine some assets with a short-term payoff and some with long-term potential. 

For instance, a move towards electric vehicles (EVs) is likely to transform the global landscape of transportation. As this occurs, EV stocks and ETFs, battery metal commodities and EV-related real estate are likely to perform well. However, mainstream EV adoption remains some way off, so assets related to the EV revolution would be long-term investments. 

Ensuring that you have a balance of long-term and short-term assets in your portfolio can allow your returns to peak at different times, enhancing your overall returns.  

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What should be in your portfolio? 

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This really depends on what kind of investor you are. Different investors will desire different levels of diversification due to a varying tolerance of risk and different priorities. Do what works best for you and execute a clear, well-concocted strategy that is based on your own needs. 

In addition, your access to different investments will vary by country, and this will affect your ability to add certain assets to your portfolio. Your knowledge is also key – for example, if you know nothing about cryptocurrencies, they probably shouldn’t be in your portfolio until you have taken the time to learn about them. 

Broadly, we recommend that the majority of your portfolio is comprised of low-risk, sustainable assets that are in safe jurisdictions and are tailored towards the long term. You can then add some higher-risk assets into the mix with greater short-term growth potential. Remember to follow our three steps closely when completing this process. 

Pros and cons of diversification 

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Below, we have outlined the advantages and disadvantages of diversification.

Pros

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  • Reduces the overall risk that your portfolio is subjected to
  • Ensures your portfolio has the balance to withstand a wide range of financially damaging mechanisms, such as market volatility
  • Long-term returns are likely to be superior due to the consistently strong performance of your portfolio

Cons

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Factors that affect diversification 

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The three key things that affect how well you can diversify your portfolio are time, expertise and capital. 

Time

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If you don’t have enough free time to commit to diversification, your results will be limited. Moreover, you will be unable to actively manage your portfolio in a way that maintains optimal variety. 

However, there are workarounds. Some assets, such as ETFs, have already been diversified for you, while things like mutual funds can provide you with the opportunity to have a fund manager put the groundwork in for you, actively managing your portfolio to maximise diversification. 

Expertise

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If you don’t understand the market and the wide variety of conditions that can affect it, diversification can be difficult. It can be hard to differentiate between long-term and short-term assets, and the complexity of reading the market can make it hard to get the information you need to make good decisions, both pre-emptive and reactive.

Once again, there is a workaround for this: seek professional financial advice, or invest in actively-managed funds. Alternatively, you can use our courses to bolster your knowledge so hedging becomes a breeze. 

Capital

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If you don’t have enough money to spread across multiple asset types, locations and timeframes, your options will be limited. There isn’t really a way of avoiding this reality – simply diversify the best you can with the budget you have, and reevaluate the situation if your financial status changes.

It is worth noting that having more disposable capital can give you a greater licence to take risks, slightly reducing the importance of diversification.  

A quick recap of what we’ve learned

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In short, diversification is the practice of ensuring there is sufficient variety in your investment portfolio to mitigate risk based on your own personal needs. This includes how much free time you have, your level of knowledge, and the amount of disposable income you have.

Chiefly, you should diversify by combining a variety of asset types, locations and timescales, and there is additional room for variation within each of these three categories. 

Where can I learn more?

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You can learn more about investing with our easy-to-follow courses. We have linked some of them below, and you can click on one to start learning. 



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Charlie Hancox
Financial Writer
Charlie is a Financial Writer for Invezz. He covers commodities, cryptocurrencies, and breaking news. Prior to joining Invezz he helped grow Crux Investor into the fastest-growing... read more.