By diversifying your investments across multiple asset classes and industries, you are reducing your exposure to the risk of a singular event significantly impacting the overall value of your portfolio.
For example, Roger’s portfolio is entirely made up of cryptocurrencies, but Emma’s portfolio is well-diversified across a range of different asset classes and industries (including a small allocation of cryptocurrencies). If the cryptocurrency market experiences a significant and sudden downturn due to internal or external market influences, Roger’s portfolio will likely be all but decimated, whereas Emma’s portfolio will only be impacted proportionately to the weighting of cryptocurrencies within her portfolio.
When constructing your portfolio, it’s important to think about what percentage of your portfolio you would want to allocate to any given asset class. This allocation should be aligned with your risk tolerance, investment plan and financial goals.
For example, if cryptocurrencies are the only type of asset that you own—that is, your portfolio is made up entirely of cryptocurrencies—perhaps consider the implications of having the entire value of your portfolio being dependent on a single asset class, especially one as risky and volatile as cryptocurrencies.
By being over-leveraged in cryptocurrencies alone you may be maximising the upside potential of your portfolio, but you are also maximising the risk of downside. If the broader cryptocurrency market were to crash, your portfolio would suffer heavy losses compared to a diversified portfolio.
Diversifying your portfolio can help reduce your volatility. Generally speaking, when your portfolio is well-diversified, you’re reducing risk and increasing your upside opportunity by hedging your investments over multiple asset classes rather than gambling on one or two asset classes.
Generally, investors with a short time horizon (for example, those nearing retirement) are willing to sacrifice upside potential in exchange for stability and preserving the value of their capital and investments. Investors with a larger appetite for risk may be more likely to entertain more aggressive strategies in riskier asset classes. Regardless, some level of diversification is an important risk-minimisation strategy for all investors regardless of risk appetite.