How does diversification reduce risk?

Could diversification improve your portfolio performance?

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

For many investors, the most important consideration when investing is the potential return. After all, it is the returns which attract all investors to buying and selling shares. However, by focusing on risk, it may be possible to enhance the overall performance of a portfolio.


While diversification in its simplest form is relatively simple, it can prove to be highly varied. For example, buying a number of different companies may reduce company-specific risk and guard against the effects of issues such as profit warnings and poor strategy within one organisation. However, even with a long list of different companies within a portfolio, an investor may still be exposed to a wide range of risks which can largely be diversified away.

Geographic risk

For example, geographic risk presents a continuing problem even as globalisation advances. The returns in different economies have varied considerably in recent years, which means that an investment in a slower-growing economy may have had a large opportunity cost. As such, buying shares in companies which operate in multiple regions could be a means of reducing risk in future. Similarly, buying stocks which report in different currencies could be a means of reducing foreign exchange risk.


Diversifying between stocks with different growth attributes is another means of reducing portfolio risk. In other words, some stocks may have earnings that have high positive correlation to the performance of the wider economy. This means that they may register wild swings in profitability during different parts of the economic cycle. Marrying them with more defensive stocks which have earnings that are less dependent on the wider economic outlook could mean less volatility for the investor, as well as more consistent returns.

Maturity and dividends

While all investors will have differing views on dividends, it can make sense to invest in a range of companies based on their maturity. In other words, owning some younger companies which offer higher growth, but that need to retain capital in order to grow, could be a sound strategic move for the long term. Likewise, owning mature stocks which require only a small portion of profit to be retained each year for growth could mean a more balanced portfolio. They could provide an income return for an investor which can then be reinvested in other shares.


Clearly, diversification does not eradicate all risks from a portfolio. Neither should it seek to simply match the returns of the wider index, since there would be little value in attempting to build a portfolio when a tracker fund could achieve the same return goal. However, by attempting to diversify key risks such as company-specific risk and geographic risk, while also having a mix of young and old companies, it is possible to generate a more attractive risk/return ratio for the long run.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

More on Investing Articles

Investing Articles

2 industry-leading value stocks investors should consider buying

These value stocks are at the top of their respective industries, and look like current bargains with the potential to…

Read more »

Black father and two young daughters dancing at home
Investing Articles

Just released: our 3 top small-cap stocks to buy before August [PREMIUM PICKS]

Small-cap shares tend to be more volatile than larger companies, so we suggest investors should look to build up a…

Read more »

Investing Articles

If I’d put £5k in a FTSE 100 index fund 10 years ago, here’s what I’d have now!

Charlie Carman explores the performance of the FTSE 100 index over the past decade and the merits of passive versus…

Read more »

Investing Articles

£15K stashed away? I could turn that into a second income worth £49 a day!

This Fool explains how she would look to gain a second income through investing in UK stocks, and the steps…

Read more »

Smiling white woman holding iPhone with Airpods in ear
Investing Articles

With the Apple share price near an all-time high, would I be crazy to buy more?

After touching all-time highs yesterday, the Apple share price is on a roll. But is there still enough growth ahead…

Read more »

Investing Articles

Nvidia stock has fallen 13% from its 52-week high! What next?

Our writer explains why Nvidia stock has dipped recently and highlights some risks associated with investing in the AI leader…

Read more »

Investor looking at stock graph on a tablet with their finger hovering over the Buy button
Investing Articles

The AstraZeneca share price is up 88% in 5 years, but is it just getting started?

The AstraZeneca share price has had a great few years, as acquisitions and clinical trials delighted shareholders. So is there…

Read more »

Investing Articles

Here’s why I’m watching the Anglo American share price

The mining sector has always interested investors. But after a flat few years, I'm wondering what's next for the Anglo…

Read more »