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If we could see into the future, there would be no need to diversify our investments. We could merely choose a date when we needed our money back, then select the investment that would provide the highest return to that date. It might be a company share, or a bond, or gold, or any other kind of asset. The problem is that we do not have the gift of foresight.

When you start investing, or even if you are a sophisticated investor, one of the most important tools available is diversification. Whilst ‘do not put all your eggs in one basket’ is a well-used adage, it is still relevant today and means, do not have all your money in one place as you could lose it all in one go.

Reducing the risk of your overall portfolio

Diversification allows you to spread risk among different kinds of investment asset classes, to potentially improve investment returns. This helps reduce the risk of your overall portfolio under-performing or losing money.

With some careful investment planning and an understanding of how various asset classes work together, a properly diversified portfolio provides an effective tool for reducing risk and volatility without necessarily giving up returns.

If you have cash and access to more than six months’ worth of living expenses – you might consider putting some of that excess into investments like shares and fixed interest securities, especially if you are looking to invest your money for at least five years and are unlikely to require access to your capital during that time.

Changing the mix of assets to reflect the prevailing market conditions

Diversification helps to address this uncertainty by combining a number of different investments. In order to maximise the performance potential of a diversified portfolio, managers actively change the mix of assets they hold to reflect the prevailing market conditions.

These changes can be made at a number of levels, including the overall asset mix, the target markets within each asset class and the risk profile of underlying funds within markets. As a rule, an environment of positive or recovering economic growth and healthy risk appetite would be likely to prompt an increased weighting in equities and a lower exposure to bonds.

Affecting the weighting between markets within equities and bonds

Within these baskets of assets, the investment manager might also move into more aggressive portfolios when markets are doing well and more cautious ones when conditions are more difficult. Geographical factors such as local economic growth, interest rates and the political background will affect the weighting between markets within equities and bonds.

In the underlying portfolios, investment managers will normally adopt a more defensive positioning when risk appetite is low. For example, in equities they might have higher weightings in large companies operating in parts of the market that are less reliant on robust economic growth.

A diversified portfolio is essential to any long-term investment strategy

Conversely, when risk appetite is abundant, underlying portfolios will tend to raise their exposure to more economically sensitive parts of the market and to smaller companies. Whether the market is bullish (rising) or bearish (falling), maintaining a diversified portfolio is essential to any long-term investment strategy.

If you are heavily invested in a single share of a company – perhaps your employer – start looking for ways to add diversification. Diversification within each asset class is the key to a successful, balanced portfolio.

Having your money in as many different sectors of the economy as possible

You need to find assets that work well with each other. True diversification means having your money in as many different sectors of the economy as possible. With shares, for example, you do not want to invest exclusively in big established companies or small start-ups. You want a little bit of both (and something in between, too). Mostly, you do not want to restrict your investments to related or correlated industries.

With bonds, you also do not want to buy too much of the same thing. Instead, it makes sense to purchase bonds with different maturity dates, interest rates and credit ratings.