The power of diversification
26th February 2020
Insulating your portfolio from any market uncertaintY Brexit is by no means the only cause of market volatility. Whether you believe Brexit will prove a blessing or a curse for the British economy, it’s important to insulate your portfolio from any market uncertainty.
One of the most effective ways to manage investment risk is to spread your money across a range of assets that, historically, have tended to perform differently in the same circumstances. This is called ‘diversification’ – reducing the risk of your portfolio by choosing a mix of investments.
In the most general sense, there are many adages: ‘Don’t put all of your eggs in one basket’, ‘Buy low, sell high’, and ‘Bears and bulls make money, but pigs get slaughtered’. While that sentiment certainly captures the essence of the issue, it provides little guidance on the practical implications of the role that diversification plays in a portfolio. And, ultimately, there is no such thing as a ‘one-size-fits-all’ approach.
Different life stages
Different investors are at different stages in their life. Younger investors may have a longer time horizon for their investing than older investors. Risk tolerance is a personal choice, but it’s good to keep perspective on personal time horizons and manage risk according to when access to funds from different assets is needed. If cash is needed in the near term, it is better to sell an asset when you want to sell it rather than when you have to sell it.
Under normal market conditions, diversification is an effective way to reduce risk. If you hold just one investment and it performs badly, you could lose all of your money. If you hold a diversified portfolio with a variety of different investments, it’s much less likely that all of your investments will perform badly at the same time. The profits you earn on the investments that perform well offset the losses on those that perform poorly.
While it cannot guarantee against losses, diversifying your portfolio effectively – holding a blend of assets to help you navigate the volatility of markets – is vital to achieving your long-term financial goals while minimising risk.
Although you can diversify within one asset class – for instance, by holding shares (or equities) in several companies that operate in different sectors – this will fail to insulate you from systemic risks, such as international stock market volatility.
As well as investing across asset classes, you can further diversify by spreading your investments within asset classes. For instance, corporate bonds and government bonds can offer very different propositions, with the former tending to offer higher possible returns but with a higher risk of defaults, or bond repayments not being met by the issuer.
There are four main types of investments, known as ‘asset classes’. Each asset class has different characteristics and advantages and disadvantages for investors. An asset class is a broad group of securities or investments that have similar financial characteristics.
Traditionally, there are four main asset classes:
• Fixed-interest securities (also called ‘bonds’)
Effective diversification is likely also to allocate investments across different countries and regions in order to help insulate your portfolio from local market crises or downturns. Markets around the world tend to perform differently day to day, reflecting short-term sentiment and long-term trends.
There is, however, the added danger of currency risk when investing in different countries, as the value of international currencies relative to each other changes all the time. Diversifying across assets valued in different currencies, or investing in so-called ‘hedged’ assets that look to minimise the impact from currency swings, should reduce the weakness of any one currency significantly decreasing the total value of your portfolio.
Achieving effective diversification across and within asset classes, regions and currencies can be difficult and typically beyond the means of individual investors. For this reason, some people choose to invest in professionally managed funds that package up several assets rather than building their own portfolio of individual investments.
Individual funds often focus on one asset class, and sometimes even one region, and therefore typically only offer limited diversification on their own. By investing in several funds, which between them cover a breadth of underlying assets, investors can create a more effectively diversified portfolio.
Less volatile returns
One alternative is to invest in a multi-asset fund, which will hold a blend of different types of assets designed to offer immediate diversification with one single investment. Broadly speaking, their aim is to offer investors the prospect of less volatile returns by not relying on the fortunes of just one asset class.
Multi-asset funds are not all the same, however. Some aim for higher returns in exchange for assuming higher risk in their investments, while others are more defensive, and some focus on delivering an income rather than capital growth. Each fund will have its own objective and risk-return profile, and these will be reflected in the allocation of its investments – for instance, whether the fund is weighted more towards bonds or equities.
Stock markets can be unpredictable. They move frequently – and sometimes sharply – in both directions. It is important to take a long-term view (typically ten years or more) and remember your reasons for investing in the first place.
Be prepared to view the occasional downturns simply as part of a long-term investment strategy, and stay focused on your goal.
Historically, the longer you stay invested, the smaller the likelihood you will lose money and the greater the chance you will make money. Of course, it’s worth remembering that past performance is not a guide to what might happen in the future, and the value of your investments can go down as well as up.
Time to grow
Give your money as much time as possible to grow – at least ten years is best. You’ll also benefit from ‘compounding’, which is when the interest or income on your original capital begins to earn and grow too. There will be times of market volatility. Market falls are a natural feature of stock market investing. During these times, it is possible that emotions overcome sound investment decisions – it is best to stay focused on your long-term goals.
Resist the temptation to change your portfolio in response to short-term market movement. ‘Timing’ the markets seldom works in practice and can make it too easy to miss out on any gains. The golden rule to investing is allowing your investments sufficient time to achieve their potential.
Warren Buffett, the American investor and philanthropist, puts it very succinctly: ‘Our favourite holding period is forever.’ Over the long term, investors do experience market falls which happen periodically. Generally, the wrong thing to do when markets fall by a reasonable margin is to panic and sell out of the market – this just means you have taken the loss.
INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.
THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.
PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.