What’s diversification?
Diversification is when investors put their money into a variety of assets in order to reduce the risk of losing money.
The logic behind diversification is that holding a range of assets will mean you are never overexposed to the risks of one industry or market.
How does diversification work?
Diversification is very simple. It’s when an individual investor or company puts their money into a range of assets
For example, a big investment company with lots of money might hold cash and also invest in energy stocks, bonds and real estate.
The effect of this is to reduce the risks of losing money associated with each of those asset classes.
If the energy market crashes but the real estate industry booms, the company in our example could end up making money or losing less than it otherwise would have if all of its holdings been in the energy sector.
Diversification with small amounts of money
If you’ve got a lot of money then investing in these different classes might be straightforward. Unfortunately, not all of us have the money to buy real estate and invest in the stock market.
Thankfully, diversification doesn’t require you to have bags of money and there are other ways of doing it.
Having a diversified investment portfolio could mean that you just invest in stocks — you’d just have to invest in a wider range of stocks to make sure your portfolio is sufficiently diverse.
For example, you could put money into stocks in the energy, media, travel, tech and financial industries. Though there may be some connections between them, it’s less likely that shares in those industries would rise and fall in unison, allowing you to protect yourself from the risks associated with each.
Today, you can also invest in funds and trusts on stock exchanges. These investments generally let you invest in a wider range of industries or let you put money into a sector that would otherwise require a lot of money.
For example, a real estate investment trust (or ‘REIT’) will invest in property but its shares might only cost £10. So you could invest in the real estate market using a REIT, without having to buy a house or office building yourself.
Similarly, an exchange-traded fund (or ‘ETF’) will generally track a range of stocks and give you exposure to all of them. The Vanguard FTSE 100 UCITS ETF GBP, for example, tracks the performance of the largest 100 UK companies, so investing in it would help diversify your holdings.
Important information
When you invest, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you invest.
Freetrade does not give investment advice and you are responsible for making your own investment decisions. If you are unsure about what is right for you, you should seek independent advice.
