One of the most common and enduring pieces of advice around investing is portfolio diversification, and there's a good reason why. Diversifying your portfolio - when done with thought and care - can reduce investment risk and improve your overall outcome.

The idea is simple. Investing all your money into one single stock also means exposing yourself to maximum risk should things go wrong. Instead, if you split your budget over several different stocks, there is less risk of your whole portfolio being entirely wiped out at once.

Why portfolio diversification is important

The likelihood of multiple stocks all going to zero simultaneously is far lower than simply having, say, two or three stocks. And the risk becomes lower still, if you go further and spread your investment funds among different asset classes - some of which have been seen to exhibit negative correlations in price action.

Also, consider that markets are inherently volatile, and no legitimate investment or asset ever only goes upwards on the price charts. There are bound to be downtrends and corrections in the markets, even during the most bullish periods.

Now, this is where investing can get tricky. When faced with price drops, investors may overreact and sell off their holdings to cut the losses, only to miss out when the market inevitably rises again.

Portfolio diversification is an ideal strategy to prevent such costly mistakes. By investing in different asset types and across several different holdings, the effects of individual price movements are blunted, making downturns easier to get through.

With variety in your investments, you also stand to benefit from more segments of the market, reducing the temptation to make speculative bets.

Five ways to diversify your investment portfolio

Increase the number of holdings

One of the most direct ways to diversify your portfolio is simply to increase your number of holdings. Investors who are just starting out and have limited funds to work with tend to focus only on a few stocks that they have conviction in.

There's certainly nothing wrong with this, but instead of buying the same three stocks over and over, it might be worth adding other stocks to your portfolio - and doing so sooner rather than later.

This will smoothen out volatility in your portfolio, and make investing less anxiety-inducing when the markets inevitably turn red.

Invest in negatively correlated assets

In simple terms, this means splitting your money across asset classes that tend to move in opposite directions to each other; i.e., when price falls in one, prices rise or stay the same in the other.

One example is stocks and bonds. This is not an exact science, but generally, it has been noticed that stocks and bonds tend to behave this way. When the stock markets go into a downturn, investors tend to turn to the bond markets in their quest for safer returns.

Bonds - which are backed by entities such as the US government - are seen as less risky. They also offer more stable returns, explaining why investors would make the switch when there is turmoil in the stock markets.

In any case, by investing in negatively correlated assets, investors can reduce the negative impact of a downturn in one market, by having the other asset as a counterbalance.

Include both cyclical and non-cyclical businesses

Some sectors are naturally resilient in all economic conditions, while others only shine during periods of strong economic growth, and falter when consumer spending dwindles.

For example, the rate of consumption for Coke may remain more or less the same even during high inflation, but demand for products like personal laptops and desktops may fall as consumers prioritise spending on essential items.

That's not to say computer company stocks aren't worth it. When the economy returns to strength, and consumers feel more confident about spending, demand for new computers will likely surge again, pushing up stock prices.

Thus, investing in sectors with different business cycles can be another useful strategy for portfolio diversification.

Invest in different, but complementary, sectors

Portfolio diversification isn't limited to mixing and matching opposing securities or asset types. Another tactic that may work well is to invest in different securities that share a common characteristic.

For example, you might fill your investment portfolio with an eclectic mix of stocks from tech companies, pharma giants, consumer goods, etc - and all of them have shown double digit growth for the past five years.

This way, instead of focusing solely on a narrow range of industries that have been hogging the headlines, you allow yourself to broaden your horizons to include equally valuable companies from sectors you may have overlooked before.

Make liberal use of ETFs

When it comes to portfolio diversification, Exchange-Traded Funds (ETFs) essentially work like a shortcut.

There is an astounding array of ETFs available today, covering virtually every asset class, geographic region, sector or industry you can think of. Each ETF is structured to track the performance of a basket of securities, and may be arranged according to characteristics such as industry or sector, geographic region, market capitalisation or asset types.

Importantly, these funds are composed of different stocks and assets picked by professional managers, and may undergo periodic rebalancing or adjustments as they try to achieve above-benchmark returns.

This means that with ETFs, investors do not have to pick their own stocks and securities to invest in. Neither would they have to keep track of several different companies and prices.

Instead, they can simply buy shares of an ETFs that focuses on the asset classes they are interested in. For instance, they can purchase QQQ for high-growth tech stocks, VNQ for real estate, IBB for biotechnology, GXD for gold, etc.

Do be aware, though, that ETFs come with management fees, which reduces your overall returns. Hence, be sure to avoid having too many high-cost ETFs in your portfolio.

Things to watch out for when diversifying your portfolio

Diversifying for no reason

As discussed throughout this article, diversification is immensely helpful. However, it's also possible to go too far in the other direction, diversifying for no rhyme or reason such that you end up with a messy and unfocused portfolio.

Having a little bit of everything will likely get you nowhere. Instead, what you want to do is to focus on a few themes that align with your preferences and convictions.

For instance, if you believe AI is the future, you can diversify your AI stocks by including a mix of established companies and promising startups.

Not removing stocks or assets regularly

Portfolio diversification isn't a one-time exercise. You should review your portfolio regularly and perform housekeeping on your holdings for optimal results.

If there are stocks or assets you no longer want to hold, don't be afraid to sell them off so you can invest in new, more promising assets, or increase your shares of winning stocks. This will help you enhance capital efficiency.

Picking the wrong entry/exit point

Portfolio diversification involves both adding and removing stocks, and the key is to pick the right time to do so.

You don't want to buy into stocks at all-time highs, as that will increase your cost basis. It will also mean having to endure an imminent drop in prices, and a long wait until the next high is made. Instead, you should keep track of well-performing stocks, and buy into them when the price comes down - which will inevitably happen.

The same principle applies when selling off holdings you no longer want. As far as possible, try to sell when you're at least at breakeven, and not at prices that would cause you to take a loss.

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This article was first published in ValueChampion.