Diversification is the process of mixing different types of assets in your portfolio. This ensures that, when a particular asset performs badly, its poor returns are offset by another, better performing asset.
Diversification also prevents your portfolio from being wiped out. For example, if all your stocks are in a single company, the closure of that company would destroy your whole portfolio.
A key part of diversification is choosing lowly correlated assets. That is, assets that have as little to do with one another as possible.
If you were to buy shares in a gold mining company, units in a gold fund, and then physical jewellery, you may think your portfolio is diversified. After all, these are not the same kinds of assets.
But if the price of gold were to plummet, all of those assets would be affected at once. This is because they’re all tied to by gold prices, and hence have a high degree of correlation.
If you wanted to be diversified, you could instead have assets in a transport company, a property developer, a food supplier, and an electronics manufacturer. There is a low correlation between these industries, so it’s unlikely that they’ll all sink or rise at the same time.
Of course, picking such a diverse range of assets can be difficult. This is why it’s a good idea to speak to a wealth manager – you want to diversify, but not to the point of buying random junk!