Why diversification is important when investing – Millennial Money
In this week's millennial money episode, Damien and I tackle jargon terms for beginner investors. This week we discuss, why diversification is important when investing and the introduction of asset allocation.
What is diversification?
When you invest you have a choice of what type of asset you want to invest your money in. An example of an asset is cash, property, gold or even a share in a company. Which of
those assets you choose will depend very much on your own attitude to risk and each of those asset classes carry different risk-return metrics.
If we take cash for example, it's very low risk and the only real risk to you is that the bank that you put your money in might collapse. Even then, most banks will be covered by the Financial Services Compensation Scheme (Check here to see if the bank you use is covered).
If you move up the spectrum and go towards bonds and end up investing in things like equity or even if you went to fine arts or wine, the risks increase and that means you've got a greater chance of losing money. With the greater risk of course comes greater opportunity to make money as well as lose it.
Different assets have different risks. You don't have to pick just one, you could pick a bit of each and have a combination. If you are not so worried about the risks and are comfortable with losing some money along the way then you might opt for more assets towards the higher end of the risk spectrum. If you're somebody who is risk-averse then you'll go down the lower end however by putting assets together you can diversify your portfolio, which is spreading the risk. This is the definition of diversification.
Diversification is important because not all of the assets move in the same direction. For example, if the stock market is going up and there's a lot of rewards for the risks that are being taken, then bonds tend to move in the opposite direction. It's not a 100% correlation but there's a tendency that when equities go up bonds might fall.
So, by picking a range of assets and diversifying your portfolio and picking different asset types, (ones that move in opposite directions) it means that you diversify the risks and protect yourself against a stock market collapse. If the stock market was to collapse and all of your money was in the stock market, you'd lose a lot of money, however, if you're holding other assets as well, then it can help to minimise the risks.
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