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Many people are aware that it is a good idea to invest in a range of assets (e.g. cash, equities and bonds). Yet what, exactly, should the balance be not only between them – but within them. After all, there are many currencies, companies and governments which one could invest in. All of them hold different risks and potential for returns depending on the time and circumstances. In this guide, our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire offer some thoughts on what generally makes a good diversification ratio (i.e. a healthy mixture of assets within a portfolio). 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
Why diversification matters
Diversification is often referred to as “spreading out your investments”, and it serves at least two main functions within a portfolio. Firstly, it gives you the chance to invest in opportunities which you may otherwise have missed. For instance, investing all of your equities in the FTSE100 may be attractive for some British investors, yet the UK does not possess a significant set of large technology firms compared to say, the USA, which houses the likes of Google, Facebook and Microsoft. By diversifying across different markets, therefore, you can expose your portfolio to the growth potential available in more sectors/industries – perhaps focusing on those where the country in question has a strong track record (e.g. Japan with robotics).
Secondly, diversification also serves to mitigate investment risk. Take the 2020 pandemic earlier in 2020 as an example. Across the developed world, stock markets plummeted in March and April as companies wrestled with lockdowns, disrupted supply chains and reduced consumer demand. Yet in the USA, much of the “rebound” in the stock markets across 2020 can be largely attributed to its five biggest companies: Apple, Amazon, Microsoft, Facebook and Google. Any investor with at least some equity exposure in their portfolio to these companies in 2020 will, therefore, likely have seen their losses mitigated somewhat due as their revenues have kept on growing throughout the pandemic. Moreover, investors with a sizable percentage of lower-risk bonds in their portfolio may also have seen the damage dampened, since these do not tend to fall in line with equities during a bear market.
The diversification ratio – what makes a good “mix”?
All of this ushers the question, of course, about what makes a good “mixture” of investments in a portfolio. What percentage of equities to bonds should you have, for instance? What kind of split between small and large-cap businesses is healthy for your equities? Should you focus on certain industries or sectors more (e.g. healthcare and technology) over others, given prevailing market conditions in 2020?
The answer you get to these questions depends on who you ask. The famous investor Warren Buffett, for instance, told Berkshire Hathaway investors in a 2013 letter that the trustee of his wife’s inheritance was to put 90% of her capital into stocks and 10% into government bonds. Yet many financial advisers would likely recommend something closer to the opposite for someone in retirement (i.e. 70-90% in lower-risk bonds). The reason for this is that, for many people as they get older, the focus switches from growing their wealth to protecting it. Yet, with people now generally living longer – thus resulting in longer retirements where their money needs to stretch even further – some argue that investors need to be a bit more aggressive.
Two of the ultimate deciders of how you split your assets (e.g. stocks to bonds) comes down to your financial goals and your appetite for investment risk. If the idea of putting 90% of your nest egg into stocks regularly makes you feel panicked, for instance, then it likely makes sense to change the allocation. Moreover, if your ultimate goal in retirement is financial stability and also predictability, then it may be wise to consider using your pension to buy an annuity – to sit next to your state pension income. If you are looking for a higher monthly income in retirement and are prepared to see it fluctuate (due to investment performance volatility), then you might be happy to keep more of your portfolio invested in equities.
Similar considerations play out when considering different size companies, bonds with varying levels of risk/return and various industries, markets and sectors which might feature within your portfolio. Some financial advisers like to “tilt” their equities more towards smaller, “value stock” companies in certain sectors and jurisdictions – the argument being that they have higher growth potential. However, this is not always true in all environments, and small-cap equities come with their own costs/risks which may be mitigated by also holding large-caps and other asset types within your investment portfolio.
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Get in touch 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