Why Investment Diversification Matters

Diversification is a fundamental aspect of investment. It means that the assets and products within your portfolio are varied and diverse, so your exposure to any specific asset class, stock, or jurisdiction is limited. The focus of diversification is to help reduce the volatility of your portfolio over time and keep it in line with your goals.

One of the principles of successful investing is learning how to balance your risk exposure and time horizon. For instance, if you start investing for retirement at a young age but invest too conservatively, you could run the risk that your investment growth rate will fall behind inflation.

In contrast, if you invest too aggressively and within just a few years of your planned retirement age, your savings may be exposed to market volatility, eroding the value of your assets at a point when you have limited time to recoup your losses.

Diversification addresses these issues by balancing risk. As a strategy, diversification has many complex iterations, but at its root, it is simply about spreading your portfolio across several asset classes – or making sure you don’t put all your eggs in one basket.

Understanding the Main Goals of Investment Portfolio Diversification

The overarching focus of diversification is to limit the impact of volatility on a portfolio rather than to maximise returns. It’s often easiest to understand the concept by considering theoretical example portfolios.

We’ve looked at average annual returns for hypothetical portfolios over the same number of years, showing how restructuring the balance of assets can significantly impact the amount of risk the investor is exposed to.

• Example one: An aggressive portfolio with 70% developed market stocks and 30% international stocks. The average annual return is 10%, and the best one-year return is nearly 163%. However, this investor would have lost almost 68% in the worst year – far too much volatility for most investors.
• Example two: Changing the asset allocation to 49% developed market stocks, 21% international stocks, 25% bonds and 5% short-term investments tightens those extreme swings in returns and losses without having a big impact on long-term performance. This would have generated average annual returns of almost 9%, with a best single-year performance of 109% and a worst year of -52%.

This basic illustration shows how balancing a portfolio with a larger proportion of fixed-income options can marginally reduce long-term returns but make a marked difference to the portfolio’s exposure to market volatility – a compromise investors often decide is well worth making.

Why Time Horizons Should Factor Into Your Diversification Strategy

We are accustomed to thinking about their savings in terms of goals, such as investing for retirement, education, a down payment, or a holiday. However, regardless of your big-picture goals, you need to consider two things:

1. The number of years until you expect to need the money – or your time horizon
2. Your attitude toward risk, also known as your risk tolerance

If you have a goal that’s 25 years away, like retirement, your time horizon is fairly long. Therefore, you may be willing to take on additional risk in pursuit of long-term growth assuming you’ll have time to regain lost ground in the event of a short-term market decline.

That said, irrespective of your time horizon, your risk tolerance is still relevant because you need to be comfortable with any level of risk you choose to accept.

The other thing to remember is that your time horizon is constantly changing. If your retirement is now 10 years away instead of 25, you may want to reallocate your assets to help reduce your exposure to higher-risk investments, choosing more conservative options, like bonds or money market funds.

Reasons Investment Diversification Doesn’t End With Your Time Horizon

Diversification remains key to managing risk over time. In retirement, an investor’s biggest risk is outliving their assets. Just as it is never advisable to have all assets invested in stocks, it’s also a good idea to never allocate all investment funds to short-term assets if your time horizon is greater than one year.

Even once you have retired and started drawing on your investment returns, you’ll need some of your portfolio to remain engaged in growth-oriented assets that will work against inflation and continue to generate returns for the years to come.

The main takeaway is that regardless of your goal, your time horizon, or your risk tolerance, a diversified portfolio is the foundation of any smart investment strategy.

Common Inclusions in a Diversified Investment Portfolio

Although diversification cannot ensure a profit or guarantee against loss, it can help mitigate the risk and volatility in your portfolio, potentially reducing the number and severity of ups and downs.

For many investors, these four assets form the basis of their diversified portfolios. However, there isn’t a universal ‘ideal’ mix, and the right assets and products will always depend on your own circumstances.

• Developed Market Stocks: Shares in companies in developed markets like the UK, US, EU and Japan. Stocks offer higher risk but can also deliver the best growth rates over the long term.
• Bonds: Bonds offer regular interest income and carry less volatility, cushioning against the stock market’s unpredictability. Investors who prioritise safety over growth typically pick high-quality and government bonds, while accepting that long-term returns tend to be lower.
• Short-Term Investments: Shorter-term investments like certificates of deposit (CDs) and money market funds are more conservative. They provide easier access to your capital and greater stability, albeit with lower returns.
• International Stocks: Foreign company stocks issued in emerging markets can offer opportunities to engage in dynamic growth. The risks are higher, but so too are the potential returns.

We’re talking today about diversification, so it’s also worth pointing out that while many investors choose some or all of the above assets for their portfolios, they can also diversify within each asset class – such as picking stocks from various companies, sectors, or locations.

Additional Components of a Diversified Portfolio

It would be impossible to list every potential inclusion within a well-diversified portfolio, but some of the other high-demand assets include the following:

• Sector Funds: These funds, as the name suggests, concentrate on specific sectors and can be useful for investors with a large proportion of assets allocated in one industry or economic sector.
• Commodity-Focused Funds: Commodities tend to be recommended only for experienced investors, but equity funds within industries like mining, natural resources and oil and gas can provide a hedge against inflation.
• Real Estate Funds: Property funds, including real estate investment trusts (REITs), can diversify your portfolio and provide some protection against inflation risk.
• Asset Allocation Funds: Investors can use asset allocation funds to outsource the task of asset allocation to the fund manager, effectively acting as a single-fund approach.

As always, it is best to consult an experienced, knowledgeable investment manager or financial adviser, who can ensure you make informed decisions before you select assets for your portfolio.

For further information about diversifying your portfolio, analysing the spread of assets you hold, and creating a customised strategy to ensure your investments match your risk appetite and circumstances, please contact your nearest Chase Buchanan Private Wealth Management team at your convenience.

All investments carry risk, including the potential loss of capital. You should carefully consider whether investing is suitable for you, taking into account your personal circumstances, financial situation, and risk tolerance.

*Information correct as at July 2025