Professional investors often talk of the spread principle in which investments are diversified over the widest possible range in order to secure the advantages of favourable political and economic trends and minimise the disadvantages.
Diversification is an important risk management technique. If an investor spreads an investment across a range of diverse asset classes which have little correlation with one another the chance of suffering a major market loss is vastly reduced. The investments that can be chosen to avoid correlation can range across different industries, geographic areas and financial instruments (such as bonds, equities and property).
Investors can also consider taking a holding in alternative investments, such as art, stamps and high value collectables because these markets have little correction with the traditional finance markets. The only disadvantage is that the alternative investment markets, and property markets are more illiquid than the traditional stock, bond and derivative exchanges. Foreign diversification into many countries protects against currency exchange risks and diversifies the investment across the global economy.
Diversification is good discipline. It prevents the obvious temptation of placing all one’s assets in an asset class which is experiencing a boom, which by implication precedes a market fall.
Diversification enables an investor to invest in a range of asset classes which have different risk profiles such as property, equities and bonds. By investing in these in varying proportions the investor can establish a high risk portfolio rich in speculative bonds or a low risk portfolio with a greater holding in bonds according to their individual risk tolerance.
Diversification removes the risks associated with stock picking and allows the investor to follow the general fortunes of the market. Also diversification reduces risk investors should also note that the performance of their portfolio will tend towards the average for the asset class in which they are involved. A skilled or lucky investor, depending upon your point of view will achieve a greater portfolio performance at greater risk compared to the diversified player.
Diversification can also be a useful in respect of market timing. If the need arises and investments have to be sold a portfolio of investments across a range of asset classes is less likely to be sold on unfavourable terms compared to an investment in a single asset class.
Diversification is highly regarded as a basic investment discipline. For the cautious investor, or smaller player in the market who is unable to place his capital at risk it is essential behaviour.