Ironically, the true value of diversification only becomes relevant when it is too late. Seen by some as an overly pessimistic or passive approach to investment, ignore it at your peril. While nobody is suggesting you shouldn’t consider or act on opportunities before you, your core approach should be balanced and long-term.
We will now look at the different elements of diversification and how they impact your broader finances.
Balanced return
Historically, the stock market has outperformed interest rates, inflation and economies in the longer term, with many of the downturns of years gone by nothing but a blip on the larger graph. Those who have benefited most have taken a balanced approach to their returns, spreading the risk across sectors which perform differently in recessions and times of economic growth.
For example, utilities, healthcare and consumer staples are considered relatively “boring” sectors that tend to underperform in boom times but hold up better in difficult times. On the flip side, we have the technology sector, which does well in booming economies but tends to underperform during times of recession. Spreading your investments across a broad range of sectors allows you to structure a balanced approach and, ultimately, a balanced return.
Avoid excessive risk
One of the characteristics of bull markets is that many people think they will go on for years and years, often blind to what is in front of them. A prime example would be the US subprime mortgage market, which, before the 2007 collapse, was seemingly the gift that kept on giving. When the market collapsed, dragging stock markets and money markets with it, in hindsight, the signs were there.
If we look at the technology sector again, when markets are strong, they tend to attract premium ratings, often well above the market average. When the market turns down, these ratings are often slashed, switching to submarket average levels. Therefore, over-investing in a perceived “risky” sector will be all good and well in the good times, but this risky approach can decimate your portfolio in challenging times. Diversification takes in all these different sectors but helps avoid excessive risk.
Mix cash flow and capital gains
In essence, this is the need to diversify your portfolio across those companies offering attractive dividend yields and those more focused on capital appreciation. As we touched on above, the performance of these stocks tends to be very different, with high-yielding stocks seen as relatively steady, while those focused on capital appreciation will do well in the boom times and struggle in recession.
Creating a mix of cash flow and potential capital gains also allows you to utilise your income tax and capital gains allowances. This may be useful when switching funds into tax-efficient vehicles such as pensions and ISAs, where a long-term investment horizon can deliver strong returns.
Different investment timeframes
While it is important to consider diversification of your investments from day one, your lead strategy may differ as you get older. For example, in your early 20s or 30s, with one eye on retirement, you may look towards greater capital appreciation as you have significant time until retirement. As you move into your 40s, 50s and 60s, finally approaching retirement, there tends to be a switch to a more balanced approach and then a focus on income and security of capital.
This demonstrates the different investment timeframes which will influence your investment strategies and your degree of diversification. A more direct example, again, may involve the technology sector. Some of the tech giants we see today came from nothing, taking a decade or more to come to fruition. As someone approaching retirement and looking for security, would a significant 10-year-plus investment in a high-risk, potentially high-reward technology share be appropriate?
Emotional security
Last but not least, diversification is essential in creating a balanced return for your investment and emotional security. There will always be a degree of volatility in any investment, whether focused on high-yielding investments or looking towards long-term capital growth. It is finding the right mix of investments at the right time of your life to give you that security, which is essential.
Ultimately, most of us are looking to build our investments and wealth over the years to enjoy a comfortable retirement. As discussed above, a typical approach would change from more capital appreciation to income-driven as we move through the decades. This creates a degree of investment and emotional security, allowing us to enjoy our later years. Well that’s the plan!
Summary
There is no one-size-fits-all approach to investment or diversification. Any investment plan will need to consider your investment strategy and your financial situation. Diversification is the practical reality of keeping a level head, not becoming overambitious in the good times or overly pessimistic in the challenging times.
While there are no guarantees when it comes to investment, a long-term balanced approach to diversification has delivered impressive results in the past. Please call the team today if you would like to discuss your investments in more detail and the importance of diversification.