A diversified investment portfolio will usually include a broad selection of asset types and investments to make sure your exposure to any single asset or risk is limited. In other words, diversification is a great way of making sure you “don’t put all your eggs in one basket”.

The idea is that, should one of your investments fall in value, the others will either perform well and make up some of the difference – or at least not fall by as much. This way, the value of your investment portfolio can be protected.

Importantly, diversification works best if the investments in a portfolio are ‘uncorrelated’, meaning they respond differently when faced with the same risks.

One of the most common ways to diversify an investment portfolio is to invest in different types of asset classes. And there are many different asset classes to choose from.

For example, you might invest in equities (shares in publicly-listed companies), bonds, real estate, exchange-traded funds (ETFs), commodities, cash or money market investments – or alternative assets such as private equity and debt. You can invest in these directly, or via a fund.

A well-diversified investment portfolio will typically hold assets from different geographical locations. Geographical diversification is built on the idea that the pace of growth will vary in different parts of the world, and that some economies will grow while others contract.

For example, at a time when the Western economies may be heading into recession, you could diversify by investing more into other regions, where countries might be benefitting from higher growth rates.

Investors can also achieve diversification by investing in different companies based on their size, or market capitalisation. Market capitalisation (or market cap) refers to the total value of a company’s outstanding shares. It’s a good way to determine the size of the company.

Why is this important for diversification purposes? Well, you might want your portfolio to include larger companies that are big, successful and pay consistent dividends. But you might also want to hold some smaller, younger, and perhaps faster-growing (but higher risk) companies whose share prices have the potential to increase substantially in the years to come. Investing in both can give you a more rounded portfolio.

Portfolio managers often talk about diversification in terms of different types of investment strategy – especially around investing for ‘growth’ or ‘value’.

For example, a growth-based strategy will invest in companies that are expected to deliver high profits or strong revenue growth. On the other hand, a value-based strategy will invest in those companies that carry less risk and appear to be undervalued currently, and should therefore do better than expected in the future.

Choosing growth or value strategies comes with specific risks. For example, with growth companies, the anticipated growth may never materialise, meaning the investor has paid a high price for non-existent growth.

Alternatively, with value companies, their undervaluation could continue indefinitely, meaning investors never see the benefit of their ‘bargain’ buy. In this respect, diversification across the two would help the investor to potentially benefit when either growth stocks, or value stocks, are in favour.

There are other investment styles and strategies to consider too. These include things like passive and active investing, income investing and impact investing. The last of these is a fast-growing area that focuses on investments making a positive contribution to society and the environment, as well as generating positive financial returns.

Investing carries risk because the value of your investment can go up as well as down, and you may not get back the full amount you invest.

Diversification is a good way to ride out the ups and downs that invariably come with investing, smoothing out the bumps along the way. At times, when one asset class or investment type is suffering, the theory goes that others would be faring better.

A good example of this comes with what happens when interest rates go up. A bond investor will be disappointed at this news because rising interest rates push bond prices lower. However, a real estate investor would be pleased because it would increase their rental yields.

A well-diversified investor would therefore find the positive performance of some of their investments offsets or neutralises the negative performance of others. It’s important to recognise that diversification can lessen the potential reward gained, as well as reducing the risk taken, but this should mean a much smoother investment journey over time.

At Amber River, we believe a diversified investment approach drives better outcomes and performance for clients.

The primary purpose of diversification is to ensure your portfolio is capable of withstanding investment volatility and market shocks. Therefore, a combination of different investment styles, underpinned by broad diversification and strong asset allocation, is the best way to ensure your investments strike the right balance between risk and return.

An Amber River financial planner will help you create a portfolio of investments that considers all of these things alongside your investment goals, attitude to risk, and unique circumstances. It’s all aimed at ensuring your money is working to help you achieve your life’s ambitions.