How can I diversify my portfolio?

If you want to invest your money, sooner or later you'll face an important question: how can you reduce the risks of investing without sacrificing return opportunities? The answer is: through a well-diversified portfolio. That means: by spreading your money across different asset classes and markets, you can balance out fluctuations.

In this article, we explain what diversification is, how it works and the different types of diversification in investing. That way, you too can build a diversified portfolio in future.

• Portfolio: A portfolio, in the context of financial markets, is a collection of different investments, such as securities, bonds, currencies and commodities.

• Need for diversification: Due to the different risks and opportunities associated with each asset, you shouldn't underestimate the importance of diversification when building a portfolio.

• Definition: Diversifying your portfolio simply means spreading your capital across different asset classes, sectors and regions to reduce risk.

• Advantage: If you want to create a diversified portfolio, you can offset losses in some assets with stable prices or even gains in others.

What is portfolio diversification?

Diversification is an investment strategy where you spread capital across different asset classes and investment opportunities. The main aim of this strategy is to spread risk, potentially increase returns and stabilise the value development of your portfolio. By spreading your capital, the impact of negative developments in one asset class or sector can be mitigated, as other investments may still deliver positive returns.

For example, a diversified portfolio can cushion the loss of value in individual securities, such as when a company performs poorly. However, the decisive factor is the correlation between asset classes: the more independently they behave, the more effective diversification becomes.

Why is diversification relevant for your portfolio?

Investments always carry a certain level of risk and volatility (fluctuations). A higher risk can potentially offer higher returns, rewarding investors for taking that risk. Conversely, lower risk often comes with lower returns. By diversifying your portfolio, you can aim to strike a balance between risk and return that aligns with your personal financial goals and risk tolerance.

How does diversification work?

Diversifying your portfolio works by spreading capital. This allows investors to lower risk, as they're not putting all their money into a single investment.

Among other things, you can diversify your portfolio by:

• investing in different asset classes

• selecting companies from various sectors

• choosing securities in different countries and regions

When diversifying by asset class, you spread capital across different types of assets to reduce the risk posed by fluctuating market conditions in any one class.

These can include:

• Shares

• Bonds

• Funds

• ETFs

• Property

• Commodities

• Cryptocurrencies

Many investors choose several asset classes to diversify their portfolio. If, for instance, the stock market is going through a downturn, steady returns from bonds or property can help balance out losses. Commodities (e.g. gold) and cryptocurrencies can also provide additional diversification, as their value often moves independently of traditional financial markets.

Good to know: Don't just diversify your portfolio by combining different asset classes. Diversifying within each asset class also contributes to diversification. This makes your portfolio less sensitive to individual fluctuations  and helps stabilise long-term performance.

Diversification by sector and industry

Investors diversify their portfolio by spreading capital across companies in different sectors.

For example:

• Companies in the technology sector

• Firms in healthcare

• Financial services companies

• Consumer goods corporations

• Securities in leisure and tourism

This reduces the risk from poor performance in one sector and increases the chance to benefit from positive developments in others. If one sector faces challenges, others may still yield solid returns and help stabilise overall portfolio performance.

Diversification by region and country

Geographic diversification means spreading your bonds and other securities across various countries and regions. This lowers the risk associated with political and economic developments in any single country. Instead, you benefit from growth opportunities in different parts of the world. Investments in markets like North America, Europe and Asia can help reduce the impact of regional events.

Diversification by correlation

Correlation describes whether investments in a portfolio perform in similar or different ways, depending on whether they influence each other.

If there's low correlation between individual investments, they move independently  meaning they don't necessarily rise or fall in value at the same time. High correlation, on the other hand, presents a risk. Correlation is therefore a lever you should consider when diversifying your portfolio  both in selecting asset classes and choosing individual securities.

Example of portfolio diversification

Want to diversify your portfolio? Instead of investing in individual shares, you should spread your investment across multiple pillars.

A diversified portfolio might, for example, include the following spread across asset classes:

• ETFs: With just one investment, you spread your money across many securities at once.

• Shares: Combine shares from different sectors and countries.

• Bonds and property: While shares fluctuate, bonds often provide more stable returns; property can act as a tangible asset, independent of stock markets.

• Commodities or alternative assets: They help reduce risk as they often behave differently to traditional financial markets.

For a well-diversified portfolio, you could, for example, invest 40% of your capital in securities such as stocks, spread across various sectors like technology, healthcare and finance, as well as different regions like North America, Europe and Asia. A good way to diversify when investing in stocks is through stock ETFs. These are exchange-traded funds consisting of a variety of diversified stocks. The most well-known ETF is the MSCI World, which contains stocks from around 1,600 companies.

Another 30% could go into bonds of varying maturities to ensure stable interest income. Real estate investments could make up 20% of the portfolio, considering both local and international properties. The remaining 10% could be invested in cryptocurrencies, for example. This asset class can offer opportunities for high returns but is associated with higher risk. The underlying blockchain technology holds great potential for the future by enhancing transparency, security and efficiency in many areas.

The advantages and disadvantages of portfolio diversification

If you diversify your portfolio, you'll benefit from stabilisation effects but will also have to deal with increased complexity. Get familiar with the advantages and opportunities as well as the challenges and risks.

Advantages:

• Risk spreading: By investing in different assets (e.g. shares, bonds or property), you reduce the risk of a single failure affecting your entire portfolio.

• Smoothing performance: Fluctuations in individual assets can be offset by more stable components, making your overall result less volatile.

• Opportunities: By investing in different markets, sectors or regions, you can benefit from growth trends, such as those emerging in developing countries or niche industries.

• Long-term protection: In times of crisis or economic fluctuation, a broad spread of investments can help cushion losses.

Disadvantages:

• Management effort: The more assets you hold, the more effort is required to monitor, analyse and adjust them regularly.

• Costs: More positions, more transactions and various products can lead to higher fees (e.g. management, transaction fees or taxes).

• Dilution effect: If investors diversify too widely, an outstanding asset may not reach its full potential, as the performance of individual investments can cancel each other out.

• Limits of diversification: In extreme market phases, many assets can fall simultaneously (e.g. during systemic crises).

• Illiquidity: Some asset types like property or specialised funds are less liquid.

What does diversification mean in the crypto space?

Diversification in the crypto space means spreading your capital across different cryptocurrencies such as Bitcoin, Ethereum and other coins or tokens, as well as across various blockchain projects and application areas. This approach helps to reduce the risk associated with the volatility and uncertainties of individual cryptocurrencies and projects.

By investing in a wide range of coins and tokens, you can offset the impact of negative developments in one particular cryptocurrency with another. This includes factors such as:

• Regulatory decisions

• Security vulnerabilities

• Technological issues

Conversely, you benefit when another cryptocurrency experiences positive developments, such as:

• Progress

• Increasing adoption

• Partnerships with major companies

You can also invest in various blockchain projects that cover different application areas, which further contributes to the diversification of your portfolio and investments.

Examples of such application areas include:

• Decentralised finance (DeFi), which enables financial services without traditional banks

• Non-fungible tokens (NFTs), which represent digital art and collectibles

• Smart contracts, i.e. self-executing contracts on the blockchain

Want to diversify your crypto portfolio without selecting individual coins and tokens yourself? Then crypto ETFs or crypto ETPs (Exchange Traded Products) available on Bitpanda might suit you. With a single product, you invest in multiple cryptocurrencies or crypto indices at once.

Conclusion: Reduce investment risk through portfolio diversification

Portfolio diversification can help investors minimise risks, stabilise returns and smooth value development over the long term. By spreading your capital across different asset classes, sectors and regions, you protect your wealth against the impact of individual market fluctuations.

A well-diversified portfolio, for example, includes shares from various companies, complemented by bonds of different maturities, property investments, ETFs and cryptocurrencies. Diversification is therefore part of an investment strategy that can pay off over the long term when building wealth.

Further topics around cryptocurrency

If you're interested in cryptocurrency and blockchain technology, Bitpanda Academy is the right place for you. In numerous articles and videos, we cover a range of topics from the crypto and finance sectors, offering lessons for beginners, advanced learners and experts.

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