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If you’re wondering how to start investing or develop your portfolio, then at some point you will hear about diversification. In simple terms, this refers to the practice of spreading out your investments across many different markets and asset types. Rather than putting all of your eggs in one basket (e.g. by investing all your capital in one stock), this approach helps you to mitigate unnecessary risks.
This short guide intends to explain how diversification works and offers some ideas about how to develop your own strategy with your financial adviser. We hope you find this content useful. If you’d like to speak to an independent financial adviser then you can reach us via:
T: 01282 772938
Reasons to diversify
It can be tempting to put all your money into cash, a stock or some other investment type which you feel confident in. Yet each of these assets alone poses a risk to your capital. Even holding everything in cash is a risk (which may come as a surprise!). If your bank fails, for instance, then the Financial Services Compensation Scheme (FSCS) guaranteed your money up to £85,000, but everything else would likely be lost. There is also the risk that your cash might be eroded over many years due to inflation, which in recent history tends to be higher than interest rates on regular savings accounts.
Likewise, putting all of your money in one stock is a risk. If that company fails then you could lose everything. In short, there is no risk-free way to store or grow your wealth. Rather, a wise investor will find ways to mitigate investment risks, preserve capital and promote growth. This is where diversification is so useful for financial planning. By engaging in multiple markets and asset types, you can aim to access their respective strengths whilst compensation for many of their weaknesses.
Diversifying within and across
Suppose you invest £100,000 in 100 different company stocks. This offers more diversification than investing in a single stock, but your capital could still be at risk. If all of these companies occupy the same industry/sector, for example, then if that industry/sector is negatively affected (e.g. by an economic shock) then your whole portfolio could still lose disproportionate value. If, however, you considered spreading your stocks (equities) across multiple sectors, industries and markets (national and international), then it is more likely that at least some of your stocks will continue to perform well even if others struggle or fall.
Take the 2020 coronavirus pandemic as an example. Since the lockdowns across the world in the first quarter, many industries suffered whilst others thrived. Aviation, tourism and highstreet retailers were hit hard – with their stock prices falling as a result. Others such as online gaming, video-based conferencing and medical research fared much better, with some even increasing their stock price. This shows the importance of diversifying appropriately within an asset type.
Yet it’s also important to diversify across asset types. Two asset types that are often contrasted are stocks and bonds. The former generates a return for an investor by growing its stock value, which can later be sold at a profit. The latter can also be sold for a capital gain, but also grants a regular income to the investor as a fixed-income asset (since a bond is a type of “loan” given by the investor to a company/government). A bond, therefore, is unlikely to be directly affected by volatility in the stock markets – thus helping to shield an investor’s portfolio from excessive short term damage in the event of a downturn. A stock, however, can open up more long term growth potential for an investor compared to a bond, and also is not affected directly by interest rates. As such, having a range of stocks and bonds in a diversified portfolio can be a good way to help it grow in the long term and mitigate investment risk along the way.
How to diversify
The key question now, of course, is how to diversify. Which asset types should you include in your portfolio, and which investments should you select within them? What should your balance be between the different assets in your portfolio? These are important questions and the answer is likely to be affected by many factors, including:
- Your investment horizon (i.e. how long you intend to invest for).
- Your attitude to investment risk (are you, by nature, highly risk-averse or prepared to take more risk to potentially access higher rewards?).
- Your financial goals (e.g. are you primarily concerned with preserving your wealth or growing it? If the former, then you might wish to diversify your portfolio in a way that emphasises “defensive assets” such as cash and UK government bonds. If the latter, then you may wish to focus more on equities and property).
If you are interested in starting a conversation about your own situation then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938