Diversification is your first line of defence against risk in your portfolio. It’s the practice of allocating your funds across a range of investments to limit exposure to a single type of risk.
An undiversified portfolio is one that has holdings in assets that are too closely related, and this could result in higher losses during a downturn.
Example
Say you own shares in a local fuel producer and a local transport company. If your country experienced a long-running oil shortage, both your holdings would be impacted because the oil and transportation industries depend on each other.
The fuel producer would lose profits due to the limited oil supply, which could mean decreased sales. Subsequently, a fuel shortage would likely result in price hikes that could impact the transport company’s bottom line.
And depending on the severity of the shortage, the transporter could also face operational challenges if there’s no oil available to fuel its vehicles, or lose more money to importing its supply.
In the scenario above, you bought shares in two dependent sectors within the same geographic location and economic environment. So any dramatic changes to one could directly impact the other.
Think about what would’ve happened had you also bought shares in an oil company from another country – one that’s one of the biggest oil producers in the world, for instance.
| Holding | Market | Currency | Asset class | Sector |
| Volkswagen | Germany | EUR | Equities (shares) | Motor |
| British Airways | Great Britain | GBP | Equities (shares) | Travel |
| Gold Bullion Securities Ltd | USA | USD | Exchange-traded fund (ETF) | Commodities |
There are many ways you can diversify your portfolio. As you’ve seen above, you can vary your investments by the countries, sectors and asset classes you buy, and even the currencies you use to do so.
More advanced market participants can use different financial instruments, such as CFDs and spread bets, to diversify their portfolios. We’ll take a deeper look into this in the next course.
Lesson summary
- Diversification can help protect you against major losses
- It involves buying a variety of assets in different regions, currencies and sectors
- You can also diversify your portfolio by the financial instruments you choose to buy or sell
