How To Diversify Your Portfolio To Mitigate Risk
When constructing an investment portfolio, diversiﬁcation should be a top priority. If you’re a seasoned investor, you’ve likely heard the term ‘diversiﬁcation’ tossed around here and there. In short, it means spreading all your investments across different asset types or within a speciﬁc class so that the risk of losses is mitigated while increasing your exposure to other potentially excellent investment opportunities.
Allocating capital across different assets and sectors is key to lowering risk and smoothing volatility. Follow these diversiﬁcation strategies to help safeguard your investments.
The Power of Diversiﬁcation
As mentioned above, diversiﬁcation entails spreading capital among a variety of investment types. The goal is to prevent overconcentration in any single asset or sector.
With diversiﬁcation, losses in one area are balanced out by gains in another. This evens out risk and stabilizes returns. A diversiﬁed portfolio typically sees much lower volatility versus investing heavily in just one type of asset.
By avoiding putting all your eggs in one basket, diversiﬁcation helps mitigate against catastrophic losses. And exposure to a wider range of assets provides more opportunities for upside.
Major Asset Classes
When constructing a well-diversiﬁed portfolio, target representation across major asset classes:
- Stocks – Equity in publicly traded companies
- Bonds – Debt instruments issued by corporations or governments
- Real Estate – Property investments
- Commodities – Physical goods like precious metals or energy
- Cash – Money market funds and cash equivalents
Blending these core assets guarantees your portfolio doesn’t solely rise and fall based on one type of investment.
Diversifying Within Asset Classes
It’s also vital to diversify within each asset class by sector, geography, industry, etc:
- Stocks – Spread across market caps, sectors, regions
- Bonds – Include government, corporate, high-yield, and foreign bonds
- Real Estate – Invest in REITs across property types and locations
- Commodities – Allocate to energy, metals, and agricultural goods This prevents concentration in any one sub-category.
Enterprise Investment Schemes for Diversiﬁcation
One unique asset class that can contribute to diversiﬁcation is Enterprise Investment Schemes (EIS). EIS provides exposure to early-stage UK companies not found in public markets.
Key beneﬁts of adding EIS investments to a portfolio include:
- Returns uncorrelated to public stocks and bonds
- Tax reliefs to boost overall portfolio performance
- Long-run growth potential from disruptive innovations
Limiting EIS allocation to 5-10% of a portfolio allows participation in the upside while minimizing risk concentration.
Pay attention to the correlation between assets. Assets with higher correlation move in sync, reducing diversiﬁcation value. Those with lower correlation provide a better risk balance.
For example, small-cap stocks typically have a lower correlation with bonds than large-cap stocks. Alternative assets like EIS tend to have low stock correlation.
The Dangers of Overconcentration
Many portfolios fail to diversify through overallocation to a single asset like:
- Large-cap US stocks – Over 50% portfolio allocation.
- Speculative tech stocks – More than 15% of the portfolio.
- Real estate – Making up 70%+ of the portfolio.
This ampliﬁes risks when that market declines. Proper diversiﬁcation caps any asset at 20-30% of the total portfolio.
Strategies for Optimal Diversiﬁcation
Follow these guidelines to effectively diversify your portfolio:
- Spread capital across at least 5-10 asset classes.
- Limit any asset class to 20-30% of the portfolio.
- Invest across global markets for geographic diversity.
- Balance high-risk assets with low-risk ones.
- Regularly rebalance to maintain target allocations.
By diversifying across various assets and sectors, you can smooth your portfolio’s ride and mitigate risk. Keep overconcentration in check and diversity as your guiding principle.
An added bonus – Tax Incentives For UK Investors
Although various class assets can help you diversify your investment portfolio, only some have the benefit of providing tax incentives for UK-based investors. So long as you’ve held shares in the start-up for around three years on an EIS scheme, it means a tax relief of 30% of the cost of the
shares you’ve invested in the company. Not to mention, the enterprise investment scheme has other beneﬁts that make start-ups even more appealing.
The knowledge for successful start-up investing is typically more accessible than for other investment opportunities, as much of it is common sense. Furthermore, the dawn of EIS investment platforms has made start-up investments even more accessible. With just a few clicks from a keyboard, users can invest in a portfolio of expert-vetted early-stage companies with strong growth potential.