The Nobel-winning economist Harry Markowitz once claimed that portfolio diversification is the “only free lunch” in investing, and his proclamation has stuck.
By spreading your investments across different asset classes, regions, and sectors, you reduce the impact of any single area underperforming.
But diversification isn’t just about protection, as it can also open you up to areas of growth you might otherwise miss if you were too narrowly focused.
So, diversifying your portfolio not only helps manage risk but also widens your exposure to opportunities for growth, and the “free lunch” comes from this double benefit.
Read on to learn more about the importance of portfolio diversification.
Diversification can help you offset losses in one area with gains in another
One of the key benefits of portfolio diversification is that losses in one area can be offset by gains in another. If you are overly concentrated, you increase your exposure to specific risks, meaning a downturn in one market or sector could have a much bigger impact on your overall portfolio.
For instance, investors often fall into the trap of “home bias”, which is the tendency to stick with domestic markets simply because they feel more familiar or comfortable.
While this can seem like a safe choice, it may leave your portfolio too concentrated and vulnerable to regional market swings.
The chart below shows the ranked annual returns of major global indices between 2013 and 2024.
Source: JP Morgan
As you can see, performance in one year is not a reliable indicator of performance in the next.
For example, in 2020 – the first year of the pandemic – the MSCI Asia ex-Japan grew by an impressive 25.4%, while the UK FTSE All-Share fell by 9.8%. Then, the following year, the MSCI Asia fell by 4.5% and the UK FTSE All-Share grew by 18.3%.
This was due to several factors, but the response and recovery to the pandemic were key.
If you had been overly concentrated in either market during that time, you would have experienced the volatility far more acutely than if you were diversified across several regions.
The Covid-19 pandemic is an extreme example, as it was a particularly volatile time for markets, but as you can see from the table, predicting which region will do well from one year to the next is all but impossible.
As such, relying too much on any one market – whether based on region, asset class, or industry – can leave you exposed. Diversification helps cushion the blows and gives you access to a broader range of opportunities.
Diversification can help prevent knee-jerk reactions to short-term trends
By balancing losses in one area with gains in another, portfolio diversification offers a steadier and more stable path to growth.
This may also mean that you are less likely to react to short-term trends, as any losses you experience will probably be less severe.
For instance, markets recently dipped when Donald Trump announced new US trade tariffs. While many UK stocks declined, others, such as utilities and pharmaceuticals, remained relatively stable due to tariff exemptions and domestic favourability.
Had you experienced a sharp decline, you may have been tempted to cut your losses and exit the market. Whereas, if your portfolio was balanced, the downturn may have been less severe, giving you more confidence to stay the course.
Again, this is a specific example, but it demonstrates how spreading your investments rather than concentrating them in one area can offer a more balanced and stable path to growth.
Diversification can also protect you against inflation
Portfolio diversification can also help protect your wealth from losing value amid high inflation. This is because different asset classes respond to inflation in different ways.
For example, assets like property and commodities (such as gold) often perform well during inflationary periods, as their value tends to rise with prices. Certain sectors, such as energy or consumer staples, may also hold up better than others.
So, by including a mix of these assets in your portfolio, you can help preserve your purchasing power and reduce the impact inflation has on your overall returns.
A financial planner can help you build a resilient, diversified portfolio
A financial planner can help you build a diversified portfolio tailored to your goals, time horizon, and risk tolerance. Rather than reacting to short-term market trends, they can help you create a structured plan designed to spread risk across different asset classes, sectors, and regions.
Our team of independent financial advisers in Lewes is here to support you in designing such a portfolio. This could help limit the effects of market volatility on your wealth and give you a stronger foundation to capture long-term growth.
To find out more, please get in touch by emailing us at financial@barwells-wealth.co.uk or by phone on 01273 086 311.
Please note
This article is for general information only and does not constitute advice. The information is aimed at retail clients only.
All information is correct at the time of writing and is subject to change in the future.
The value of your investments (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.
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