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Diversification and why is it important?

Diversification is the process of investing money across different asset types and, usually in different proportions. The main asset types are equities, bonds, cash, property and commodities (e.g. gold, oil, coffee). The aim of diversification is to help an investor avoid being overly exposed to the fluctuations in value of one particular asset type, i.e. to spread the risk.

At the same time, it can be used to balance a range of investments. For example, increasing exposure to a particular asset type at times of opportunity. This should be done in accordance to an investor's individual financial goals, time horizon and attitude to risk. It can be a complex process and it is wise to seek professional advice.

Asset allocation is an important part of the diversification process. Different asset types tend to behave differently under the same market conditions. Typically, when shares/equities are up in price, bonds are often down in respect of returns - and vice versa. By investing in different asset types, the effect of market fluctuations in any one market or asset type is reduced, helping to smooth the returns you can expect and limit potential losses.

While diversification does not guarantee better performance, and for that matter, cannot eliminate the risk of losses, it does seek to balance risk and reward. For the professional investment managers, it is a disciplined, long-term strategy that provides a framework for balancing investments, enabling them to take advantage of rising markets and mitigate loss on the downside.

In addition to diversifying across asset types, investors can diversify within them. Investing in company shares for example, could involve choosing investments in different companies, in different industries or sectors, in different countries.

A vital prerequisite to a successful diversification strategy is a thorough appraisal of individual goals. Is the investor looking for income, growth or both? Is the investor prepared to live with some degree of your capital being at risk if it means a better chance of achieving higher returns? Are you totally 'risk averse' and do not want to risk your capital under any circumstances or are you somewhere in between?

Diversifying your investments can be a complex business. In certain circumstance, diversifying your investments can be a highly effective way of managing risk as we saw in the financial crisis of 2008. The greater the degree of economic stress, the more closely correlated global markets become, so there are fewer places to 'hide', meaning that there are fewer investment opportunities available to you. For further information, please e-mail advice@prosperis.co.uk