NOT putting all your eggs in one basket is a sound policy for your investments as well as your groceries.
Having all your investment eggs in the same stock means they all get cracked when it falls. But it’s not enough to invest in a few competing companies and hope that one will come out on top. To really avoid scrambling your portfolio, you need to be serious about diversification.
What does investment diversification really mean?
Obviously, you would not tie all your investments to the performance of a single company. But while spreading investment across a few companies can reduce the risk of losing everything in a Lehman Brothers style failure, it is simply not enough. As we saw in the financial crisis, entire sectors can go into a downward spiral.
It’s not enough to invest in more than just one company. You need investments from different market sectors, different asset classes and different countries.
Diversification can be more rewarding
Of course, all investments can fall as well as rise, and even well diversified portfolios are still at risk from market movements. However, different market sectors behave differently in response to market conditions. A portfolio that’s diversified should be less volatile. Gains may not be quite so dramatic - but the chances of loss are reduced, because any holding that underperforms should be compensated for by those that offer business as usual.
So here is the real reason for diversification. If extremes of performance - good or bad - are avoided, the portfolio should be better able to benefit from the underlying steady growth. The returns you enjoy, year in and year out should beat those you may (or may not) enjoy if you trust your investments to luck and hope to back a winner.
How to diversify
A diversified portfolio should include a wide mix of investment types, markets and industry sectors. The main types of investments are shares, bonds, property and cash. The proportion you invest in each one is referred to your ‘asset allocation’.
A mix of shares and bonds can be the ideal starting point for diversification. The performance of shares as opposed to gilts and bonds are said to be negatively correlated. Both asset classes respond to the economy as a whole, but when one has been going down in value, the other tends to go up.
The value of shares is influenced by the performance of the company itself and by general economic conditions. When the economic outlook is bleak, investors tend to move away from shares and their values fall. If the economy is performing well, investors expect companies will make increased profits, so there is more demand for company shares, and their value rises.
Gilts and bonds
A bond is essentially a loan to a company, and a gilt is a loan to the UK Government. Both pay a fixed rate of interest. This means that the value of issued gilts and bonds depends on external interest rates. If they fall, the interest rate paid by bonds becomes more attractive, and the price of bonds tends to rise. If interest rates rise, the income a fixed-rate bond offers becomes less attractive and the value of the bond falls.
So, diversification is really about careful asset allocation. The first stage might be to spread your share investment across several businesses in a numbers of sectors, essentially to broaden your holdings, and reduce the risk. The second might be to balance those equities with bond assets, helping protect you against events that affect the entire economy, and the steady round of economic cycles.
If your portfolio is large enough, you should consider allocating investment to other asset types. Property can provide steady returns and may offer the possibility of capital growth over the longer term.
Diversifying with collective investments
Managing your portfolio to achieve this kind of diversity could start to become a full time job. Keeping your holdings diversified and balanced, which could mean selling rather than buying high performing stock goes against most people’s instincts.
The answer can be to diversify through funds or collective investments. Unit Trusts, Open Ended Investment Company (OEICs) and Exchange Traded Funds (ETFs) all invest in a variety of shares, gilts and bonds or other investment types.
But while Fund investment can certainly be easier than building up your own diversified portfolio and managing it to deliver over the peaks and troughs of the long-term, it is vital to pick the right fund. Management charges and performance can vary greatly.
You might need professional help to find a fund with objectives that match your own, and which offers reasonable costs.
To discuss your investment portfolio, or any other aspect of your financial plans, call Darren Rowe or Viv Swift of Continuum on 01208 815411.
Darren and Viv have over 35 years’ experience in giving financial advice. They work across the whole spectrum of financial advice from funding the purchase of your home, saving for your retirement or protecting what matters most to you in life.
Continuum (Financial Services) LLP is an appointed representative of CAERUS Financial Ltd, which is authorised and regulated by the Financial Conduct Authority and is entered on the FCA register (www.fsa.gov.uk/register) under reference 497604
The Financial Conduct Authority does not regulate tax and trust advice.