Why I’m using diversification to improve my long-term investing strategy

Diversification is a very useful stock market investing tool for hedging against uncertainty. I think it gives me confidence in a long-term investing strategy.

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The pandemic sent shock-waves through businesses large and small. Some saw orders, sales and profits rise, while many were faced with instant closure. One glaring lesson this taught me as an investor is not to have all my eggs in one basket. Diversification is key to a long-term investing strategy and one that can help hedge against unforeseen events.

What is diversification?

Diversification means spreading the risk of losses across my entire portfolio. So, rather than putting all my money into one sector, such as health or banking, I should allocate a percentage to several sectors. This means if one sector suffers in a bear market, hopefully another of my choices will thrive. It’s not a guarantee, but diversifying offers a sensible approach to hedging against major losses.

Sectors hardest hit by the pandemic include oil, travel, recreation, construction and banking. On the plus side, tech stocks and online-only businesses profited. Certain healthcare stocks also fared well. Many traditional retailers suffered, but that wasn’t unexpected. The bricks and mortar retail sector had been suffering since the Brexit referendum in 2016.

For those retailers with an online presence that saw sales soar, it didn’t always equate to higher profits. Tesco’s sales rose strongly, but it incurred higher costs associated with implementing safe working practices. This included meeting intense cleaning regimes and boosting infrastructure and recruitment to create a growing capacity for online orders. This accumulation of problems creates volatility in the markets. Having a diversified portfolio can reduce the exposure to negative activity.

The US stock market rebounded spectacularly in 2020, with many listed companies achieving record gains. Today, the S&P 500 sits 16.7% up in a year. By comparison, the FTSE 100 is down 11%. This shows owning stocks in different countries can also prove a beneficial hedge.

Mixing up asset classes

To achieve a diversified portfolio, I like to own a selection of stocks in a variety of sectors and countries. But diversification doesn’t just have to be across equity sectors. Mixing up asset classes also hedges against a major loss. This can include investing in exchange-traded funds (ETFs), real estate investment trusts (REITs), commodities, or even physical assets such as gold coins, artwork or rare whisky.

Within ETFs, the scope for further diversification is endless. I can invest in emerging markets, foreign countries, specific industries, innovation and much more. Downsides to investing in funds and trusts, can be hidden costs or too much exposure to poor performers, which can dilute gains and losses.

When choosing my investments, I’m considering an investment horizon of over five years, as I believe this will help me pick long-term winners. I also want to keep things manageable. So I don’t want to own too many to keep track of. Managing my own portfolio means I can’t be completely hands-off.

To build wealth, I need to understand what I own and be ready to sell if a company looks to be in trouble. For a long-term investment strategy, selling would be a last resort as buy-and-hold is my ultimate goal. However, if a sector looks to be in real trouble and I’m already sitting on gains, I might sell to reinvest in a more promising area.

Overall, I feel comfortable and confident investing in a long-term portfolio using diversification to help me hedge against the unexpected.

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.

Kirsteen has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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