Diversification

Diversification is the process of dividing your wealth between different investments to avoid being too reliant on any single one doing well.

Diversification is the process of dividing your wealth between different investments to avoid being too reliant on any single one doing well. In plain English, it's all about making sure you don't keep all your eggs in one basket.

The purpose of diversification is to reduce your risk (as measured by the volatility of your portfolio), while maintaining a decent level of return. For example, if you own just one stock, then your portfolio is entirely dependent on the fortunes of that one company. If you own 15, then even if one or two perform badly, or go bust, then the others in your portfolio should help to compensate for the loss.

While there's no ideal level of shares to hold, some research suggests that once you get above 20 well-selected shares, the marginal benefits of adding more is small. However, this assumes the shares are themselves well diversified if you hold just 20 oil companies, for example, you are still heavily exposed to the risks of a single sector.

In addition, the size of each investment is important: if you have 100 shares, but half your portfolio in a single stock, you are not sensibly diversified. A good diversification strategy combines all these principles: you might set yourself a rule of holding 20 stocks, with no more than two in each sector and no more than 10% of your portfolio in a single stock (and no more than 20% in three and so on).

As well as diversification within an asset class, you should diversify between asset classes, because different assets tend to behave in different ways depending on the economic backdrop. For example, bonds will do well during periods of falling or low inflation, while gold tends to benefit during periods of financial instability.

Your exact mix of assets or asset allocation will depend on your investment time horizon and risk appetite.

Recommended

Margin call
Glossary

Margin call

When an investor borrows to bet on markets, they put down a deposit known as “margin”.
2 Apr 2021
Resource curse
Glossary

Resource curse

The term “resource curse” refers to the observation that countries with abundant natural resources also tend to be less economically developed than th…
14 Jan 2021
Balance of payments
Glossary

Balance of payments

The balance of payments refers to the accounts that sum up a country's financial position relative to other countries.
8 Jan 2021
Yield-curve control
Glossary

Yield-curve control

Yield-curve control is when a central bank aims to control long-term interest rates by pledging to buy (or sell) as many long-term bonds as needed to …
25 Dec 2020

Most Popular

China owns a lot more gold than it’s letting on – and here’s why
Gold

China owns a lot more gold than it’s letting on – and here’s why

In a world awash with money-printing, a currency backed by gold would have great credibility. And China – with designs on the yuan becoming the world’…
21 Apr 2021
“Joke” cryptocurrency dogecoin goes to the moon. What’s going on?
Bitcoin

“Joke” cryptocurrency dogecoin goes to the moon. What’s going on?

Dogecoin – a cryptocurrency created as a joke – has risen by more than 9,000% this year alone. Saloni Sardana looks at how something that began as an …
19 Apr 2021
House prices in the UK are still surging – here’s why it’ll probably continue
Property

House prices in the UK are still surging – here’s why it’ll probably continue

The latest UK house price data shows no letup in the country’s booming property market, with the biggest yearly rise since 2014. And there’s no end in…
22 Apr 2021