Diversifying your investment portfolio is essential if you want to earn the highest returns for the least risk. A diversified portfolio typically has a mixture of stocks and shares, fixed income and commodities. In essence, diversification works because these assets react differently to the same economic event.
It is vital that different assets held in your portfolio share no correlation to ensure you spread risk. This is done by choosing different types of investments and also different sectors of industry or commerce. For this reason, it is very possible to diversify your holdings within the same sector with no risk of correlation.
A good example of this is within the area of property investment. There are different types of assets including buy-to-let, build-to-rent, student accommodation, nursing homes, warehousing, etc. Each of these assets has different dynamics affecting their performance, with little correlation to each other. For instance, the opening of a new college or university will impact investment in student accommodation before its effects will reach the buy-to-let market.
Reduce Correlation to Minimize Risk Exposure
In a diversified portfolio, the assets don’t correlate with each other, which means when the value of one rises, the value of the other falls. It lowers overall risk because, no matter what the economy does, some asset classes will benefit. That offsets losses in the other assets. Risk is also reduced because it’s rare that the entire portfolio would be wiped out by any single event. A diversified portfolio is your best defense against a financial crisis.
Examples of correlation:
- Stocks and shares tend to do well when the economy grows. Investors want the highest returns, so they bid up the price of stocks. They are willing to accept a greater risk of a downturn because they are optimistic about the future.
- Bonds and other fixed income securities do well when the economy slows or when there is uncertainty. Investors are more interested in protecting their holdings in a downturn. They are willing to accept lower returns for that reduction of risk.
- The prices of commodities vary with supply and demand. Commodities include wheat, oil, and gold. For example, wheat prices would rise if there is a drought that limits supply. Oil prices would fall if there is additional supply. As a result, commodities don’t follow the phases of the business cycle as closely as stocks and bonds.
The Equity in Your Home Counts as Diversification
A type of commodity that should really be considered a separate asset class is the equity in your home. Most people don’t count the equity in their home as a property investment. This is mostly on the assumption that they will continue to live there for the rest of their lives. In other words, the majority of people view their home as a consumable product, like a car or a refrigerator and not an investment.
This attitude encourages homeowners to borrow, sometimes extensively, against the equity in their homes. This means that if house prices decline, homeowners have the potential to owe more on their properties than they are worth. This is the reason hundreds and thousands of people lost their homes during the financial crisis and an important example of negative diversification.
Borrowing against the equity in your home is a very risky business during times of uncertainty. Conversely, building equity in your home is a valuable part of structuring a diversified investment portfolio and protects your bottom line over the long-term. Using profits from other investments to pay off mortgage borrowing is one of the best ways of bringing financial independence much closer.
Managing Diversification in 2020
The most important rule of diversification is to make considered strategic decisions. It is very easy to get swept up with the latest trends even in the investment arena, particularly when there is such a wealth of opportunity.
Many analysts believe 2020 will see a recession in the UK which means they expect financial markets to broadly underperform. But that doesn’t mean you should unload your stocks and bonds for fear that one is imminent. Recessions are often short-lived, and the stock market has a proven history of recovering from downturns. Also remember that if your portfolio value declines for any reason, you don’t take actual losses unless you sell your holdings at that time.