Deciding between diversification or concentration when it comes to your investment portfolio can be a difficult choice. Choosing to have a diversified portfolio or a concentrated one can make a massive difference to your results.
In this article we’ll explore both of these methods, weighing up the pros and cons of each. This way you’ll be able to make a more informed decision about which method suits you as an investor.
What is diversification?
Diversification means having a range of different investments in your portfolio.
This could be choosing to invest your money in a variety of companies, industries, assets or countries.
There are no criteria that a portfolio needs to meet for it to be thought of as diverse. The general rule is that a diversified portfolio gives exposure to a wide range of investments.
What are the benefits of diversifying?
Diversification in your investment portfolio has its benefits:
- It lowers your level of risk because if one investment isn’t successful, you still have others that may perform.
- It can give you exposure to lots of different companies and assets, increasing the likelihood of choosing a winner.
- International diversification of investments means your portfolio is less-affected by currency movements or political issues within a country.
What are the drawbacks of diversifying?
Diversification isn’t without its drawbacks:
- By spreading out your investments, you’re likely to see less gains in areas that are successful.
- Sometimes diversifying a portfolio can make it unnecessarily complicated, confusing, and hard to manage.
- It can be harder to research lots of investments compared to just a few.
What is concentration?
Concentration is at the other end of the spectrum to diversification.
Having a concentrated portfolio means it is heavily weighted in a certain area. This could be one particular type of asset (e.g. real estate, bonds or vintage cars). It could also be buying shares from just a small number of companies, a single industry, or one country.
Again, there’s no strict rule that would make your portfolio concentrated. It should be apparent if the scope of your investments is quite limited.
What are the upsides of a concentrated portfolio?
Deciding to go for a more concentrated portfolio has a number of upsides:
- If your investment is successful, you may see greater growth and gains.
- It can be much easier to research a smaller number of investments.
- A limited portfolio can be easier to manage and track.
What are the downsides to concentrating?
A concentrated portfolio has a few key downsides:
- A higher level of risk because your portfolio is reliant on fewer investments.
- Unexpected news for a company, industry, or country could be harmful.
- A limited investment area means a greater downside if you’re wrong.
- Having fewer investments gives you fewer places to potentially succeed.
Which is better?
This will depend completely upon your goals and the type of investor you are.
If you’re just starting out, a concentrated approach can be easier to grasp. By being well-researched in a limited area you can make more informed decisions.
It’s worth taking a long-term approach and easing into things gradually. I’d recommend starting off with up to five investments and then building your portfolio as you become more knowledgeable.
A seasoned investor may also choose a concentrated approach. Concentrating investments can allow bigger and faster growth but carries a greater level of risk.
For someone more experienced or preferring less risk, diversification could be the better option. Having more horses in the race can mean you’re more likely to pick a winner. More importantly, it’s not the end of the world if you choose a couple of stinkers!
It’s still important that any additional investments are well considered. Choosing to diversify shouldn’t mean throwing a dart whilst blindfolded.
Best of both worlds?
It is possible to have the best of both worlds. You can get some of the benefits of diversification and some of the upsides of concentration.
You can achieve this by investing in an index fund, mutual fund, or ETF (exchange traded fund). Investing this way is still just a single investment, but it can give you exposure to lots of different companies or markets.
If you’re a completely new investor, you should check out our guide to share dealing. Or if you want to diversify your portfolio, take a look at our top-rated share dealing accounts where you can choose from plenty of different investments and funds.
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