One of the golden rules of investing is to spread your money across a range of different asset classes. This approach means that if one or more of your investments rise you will benefit but, if they fall, there should be a degree of protection because, hopefully, some of your other holdings in different asset classes will be going up in value. However, diversifying doesn’t mean shortening the period of time you invest over. You should be thinking long term (at least five years) for all your investment allocations.
What does diversification mean?
Diversification means making sure you’re not relying on one type of investment too heavily. This helps to protect your investments and reduce the overall risk of losing money.
There are four main asset classes – cash, fixed-interest securities, property and equities – and having exposure to them all will help reduce the overall level of risk of your investment portfolio. If one part of your portfolio isn’t doing well, the other investments you’ve made elsewhere should compensate for those losses.
It can work on so many levels
Investing in just one company is extremely risky, because if it doesn’t perform you’ll lose money. Investing in lots of companies means that even if one does badly, others may do well, limiting your losses.
You can further diversify your portfolio by spreading your investments over several geographical areas. If you invest in companies from different countries then even if, say, manufacturing is performing poorly in the UK, it might be flourishing in the Far East. You can take this up another level by investing in different sectors. And so if manufacturing underperforms in several countries at once, other sectors you’re investing in could be outperforming their markets.
Make sure you are comfortable with the risks involved when investing in different regions. For example, emerging markets such as Brazil, Russia, India and China are likely to be more volatile than developed markets such as the UK and US.
Funds – diversification made easy
You can gain access to several different geographical areas through managed funds such as unit trusts, Open-Ended Investment Companies (OEICs) and investment trusts.
These are collective investments, whereby your money is invested with other investors in a range of different holdings. Some funds focus on a specific area, type of investment or sector, while others are more general and invest across several regions and sectors.
Fund managers publish information about the underlying asset allocation of a fund, so make sure you look at this before investing.
Thinking about risk and return
Diversification isn’t a magic bullet and it won’t stop you experiencing losses. But it can help you spread your overall risk. Do remember, though, that you can’t get rid of risk completely. Any investment can go up or down in value and you could make or lose money. The key is to find a spread of investments and a level of risk and return that you’re comfortable with.
Assets like bonds and gilts can help offset riskier investments like shares, but the downside is they don’t offer the same potential for higher returns. Cash investments are also less risky than shares, but if the cost of living rises ahead of any interest you’re getting, your money could actually fall in ‘real’ value over time.
The investments you pick for your portfolio will depend on how long you plan to invest (which should be for at least a five year term), how much risk you’re happy to take and your financial objectives. If you’re not sure which investments to choose, you may want to get independent financial advice.
No matter what approach you take to diversification, you have to accept that you can still get back less than you invest.
The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice or contact us to discuss with a free consult.