Introduction to investment diversification

Introduction to investment diversification

In our previous edition of Money Matters, we discussed the three steps to investment success: define clear goals; invest with balance and diversification and stay disciplined in the long term. In this edition we’re going to take a closer look at the proven investment strategy of balance diversification and exactly what it means in practice.

Most investors are used to hearing the term ‘diversification’ – but it has a broader meaning than many realise. In the simplest terms, it’s summed up by the old homily; “don’t put all your eggs in one basket”.

However, this doesn’t really give the full picture. To put this into practice you’ll need some further insight into how a diversified portfolio is created, and how it mitigates risk. Investors also need to consider whether there can be such a thing as too much diversification – can you have too much of a good thing?

What Is Diversification?

In essence, diversification means taking steps to ensure that your portfolio of investments contains enough variety to minimise risk. For example, if you decided to invest in the stock of just one company, if that company took a nose dive, then your entire portfolio would be affected.

If you had split your investment between two different companies, then of course, only 50% of your portfolio would be affected by the downturn. So by spreading your investments you can reduce the overall risk to your portfolio. However, it’s not just about the companies you invest in. There are several factors to consider when looking to balance your portfolio – and the balance you choose depends upon your appetite for risk and your long term investment goals.

Chalk & Cheese- Choosing your mix of Bonds and Equities

Diversification is also about the type of investments you choose. You can choose to split your investments between equities, bonds and cash. Cash investments can be excellent when used as a short term  reserve, and it’s never a bad idea to keep at least a portion of your invested assets in cash or other short term securities. You can then access a portion of your capital relatively easily in case of emergency or in case a new investment opportunity arises. But it’s also wise to include equities and bonds as part of your portfolio with a longer term strategy in mind.

This mix of asset allocation in your investments is what is meant by a ‘balanced’ portfolio. The specific  balance of asset classes in a given portfolio is designed to create a specific risk-reward ratio that offers the opportunity to achieve a certain rate of return on your  investment in exchange for your willingness to accept a certain amount of risk.

In general, the more risk you are willing to take, the greater the potential return on your investment, however, remember that this can also mean greater risk of loss. When creating a portfolio that contains both stocks and bonds, aggressive investors could, for example lean towards a mix of 80% stocks and 20% bonds, while conservative investors may prefer a 20% stocks to 80% bonds mix. It’s a good idea to discuss with your adviser what specific asset allocation will suit your requirements. If you’re clear with them about what you want to achieve, they can help you find the right strategy for you.

A Whole New World

Diversification goes beyond asset classes. You should also think about the geographical spread of your portfolio. Many investors exhibit a tendency to stick to their own country when investing. This is termed home bias. It occurs for several reasons; there are additional costs to investing overseas and many investors feel they know more about the market in their own country and are therefore more comfortable investing there. In the UK the natural bias of investors is to only consider the FTSE 100 Index – despite the fact that it includes only 100 of the 15,000 globally eligible companies. The UK market as a whole accounts for just 5% of the global economy.

You could be limiting your options quite severely if you do not consider the global equity market. Investing globally also increases your portfolio’s diversification in currency. Non-GBP currency exposure could deliver dramatic returns – however it’s important to recognise that currency movements can have significant volatility and any global bond exposure should be fully hedged (offset with other asset classes to reduce risk). Any portfolio allocation in global markets should be material enough to make a difference, but not so large that it significantly increases your risk level. Again the exact allocation will depend upon your appetite for risk and your long term investment goals – however somewhere between 5%-10% is reasonable.

Oil and Water – mixing your industry allocation

So we’ve covered asset classes, geography… What’s next? There’s another major area you need to consider as part of diversifying your profile – what industries are you investing in? Your equities should be spread across different industries to protect you from dips in specific sectors. For example, if your entire portfolio was invested in oil, you might have taken a heavy hit after the BP oil tanker disaster in the Gulf of Mexico in 2011. By diversifying into other sectors, you would have mitigated that risk. This links to the geographical diversification we talked about earlier – in the UK we have an industry bias towards sectors such as financial services and energy. By diversifying geographically, you will also find it easier to spread your risk across different sectors.

Can you have too much of a good thing?

It may seem that diversification is simple to achieve – after all, with such a huge range of investment opportunities out there, how hard can it be? Well, it is possible to over-diversify your portfolio. This is sometimes referred to as ‘diworsification’! In the same way that a diversified portfolio mitigates risk by minimising the effect each individual investment has on your overall portfolio, an over-diversified portfolio can mean that the positive effects of individual investments are also minimised – to such an extent that growth in individual investments has little or no effect on the overall portfolio. You also run the risk of overlapping holdings as well as a larger variety of expenses. There’s no ‘one size fits all’ approach to building a balanced and diversified portfolio. You need to work with your adviser and be clear about your goals, time frame and attitude to risk, so they can help you figure out the investment mix that’s right for you. But with the right advice, it’s possible to have a portfolio that meets your needs well, and you can re-visit in the future should those needs change. Please remember that any investments related to stocks and shares can fall as well as rise and the return from them may go down as well as up, it is not guaranteed, and you may not get back the amount you invested.

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