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How should you “spread out” your investments? Many people recognise that it is very risky to put all of your eggs in one basket when building a portfolio. Yet choosing the right balance of investments is not always easy. Diversification is the practice of committing money to different companies, markets and asset classes to mitigate the risks associated with each one. In this guide, our team at Cedar House explains how diversification works, some different forms that it can take and ideas for constructing a diversified portfolio. We hope this is helpful to you. If you want to discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
020 8366 4400 or enquiries@cedarhfs.co.uk
Diversification – an overview
Imagine putting all of your money into a single company stock. If the stock price later fell and the business eventually collapsed, then you could lose all of your capital. If, however, you investing the amount into, say, 100 different companies then it would matter far less if a single one failed. Diversification, therefore, reduces your risk exposure. Yet it does not eliminate it entirely.
Suppose you invested in the 100 companies listed on the FTSE 100 (the 100 companies with the highest market capitalisation listed on the London Stock Exchange). Even here, there is investment risk. If the whole British stock market goes down – e.g. due to a recession – then you may still see this portfolio fall in value. To mitigate this risk, therefore, it can help to spread out your risk not just across different companies – but also in different markets as “asset classes”.
Different approaches to diversification
When you have so many different investment “baskets” to choose from, it is inevitable that every person will end up building a unique portfolio. A range of factors can affect the appropriate set of investments that are appropriate for you. These include:
- Risk level. Are you prepared to risk more capital for the potential to attain higher returns? Startups, for instance, tend to involve greater risks (since they are more likely to fail) but could grow exponentially in their formative years. Publicly-listed companies, however, are often slower in producing stock price growth over time, but have more resources to weather financial storms if they come (such as a recession).
- Investment goals. What are you looking to get from your portfolio? Some people want to prioritise the generation of income – leading them to prefer stocks which pay a higher dividend. Others might not want any immediate income but would prefer that the portfolio grows as fast as possible.
- Time horizon. How long until you may need the money in your portfolio? As a general rule, the shorter your time horizon the less risk you can afford to take with your selection of investments. This is because you have less time for your portfolio to recover if there is a bear market, housing crash or another negative trend/event.
- Liquidity. How quickly might you need to sell your investments to turn it into cash? Some assets are more “liquid” than others. Shares, for example, can typically be sold quickly but property investments – like Buy to Let – can take a lot of time.
Diversifying within – and across – asset classes
With the above principles in mind, how do you start approaching the vast “marketplace” of potential investments for your portfolio? Imagine that your choices are arranged like aisles in a supermarket. Each aisle offers a particular “category” of items. This is similar to the different asset classes on offer to you. Traditional asset classes include equities (company shares on a recognised stock exchange), bonds and cash. Alternative investments might include slightly more “exotic” categories such as commercial property.
Knowing the broad differences between these “aisles” (asset classes) can help you decide, broadly, what percentage of your portfolio you want to allocate to each one. In general, equities tend to be higher in risk and reward; bonds offer lower returns and lower risk. For instance, you may decide that you want an 80:20 split between equities and bonds. In this case, you can now head “down the aisle” to start picking investments from within the categories.
Diversifying not only involves spreading your money across different asset classes, but also spreading out your risk within them. If equities are going to form part of your portfolio, then it is wise to consider including a range of companies from different industries (e.g. tech, energy and consumer staples). You can also spread out across various countries and regions; you are not usually limited to investing in just the UK. The USA, Canada, European countries and emerging economies may also be options for you to consider. This helps to protect your investments if a particular country or region experiences economic problems but the others are less affected.
Of course, with so many investment choices available – and so many variables that can influence your overall strategy – the benefit of professional financial advice cannot be ignored. A financial planner can not only help you survey the marketplace more thoroughly and with an experienced set of eyes, but they can also guide you to help stay on course towards your goals.
Conclusion
Interested in discussing your financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team here at Cedar House via a free, no-commitment consultation:
020 8366 4400 or enquiries@cedarhfs.co.uk