Definition: Portfolio diversification
Portfolio diversification, is about selecting a range of different investments and assets to achieve the best balancing of risk.
Handy Tip: ‘Don’t Put all Your Eggs in One Basket’
The optimal portfolio diversification comes from selecting the right balance between security and rate of return. Each investement decision can be evaluated in terms of:
- Security – Is there chance for me to lose this investment? e.g. Any type of share has the potential to lose all of its value. Just because it is in the FTSE 100 doesn’t mean that it can’t collapse in value. Just look at what happened to the Northern Rock share price in 2007. Cash in the bank, on the other hand is said to be very secure because unless the bank goes under you can withdraw your money.
- Rate of Interest. Many Investment decisions offer an annual rate of interest. For example, savings in a bank may offer 4% per year. A government bond may offer slightly more 5%. For people looking for a guaranteed income from their assets this will be an important criteria.
- Capital Growth. Some assets have greater scope for capital growth. These assets tend to be more high risk and conflict with the first – security. For example, cash in the bank will offer very slow capital growth. However, share prices can rapidly increase if the company grows faster than expected.
Getting the Right Portfolio Balance
It is worth asking a few questions to get the right portfolio balance:
- Can I afford to lose my investments? If you put all your portfolio into risky shares could you afford to lose all your money.
- Don’t be swayed by Market sentiments. Markets often get caught in speculative bubbles e.g. dot com bubble 2000. Even housing markets can get caught in speculative bubbles.