This recent period of market volatility has highlighted just how essential diversification is in helping to manage the ups and downs of market fluctuations.
Diversification means making sure your portfolio has varied investments. This can include investing in stocks and bonds, in different industries, and in large and small companies. The phrase ‘don’t put all your eggs in one basket’ has been widely used for many years when discussing investments, and it is still good advice today. It essentially means you shouldn’t have all your money in one place, as you could lose it all in one go.
Smoother return profile
By holding well-diversified assets at both a geographical and asset-class level, portfolios experience a (relatively) smoother return profile. This is because risk exposure is less concentrated.
Investment options span every sector of the stock, bond and property markets, but allocating your assets based on performance alone is often ill-advised because the market is a moving target. One year, a particular type of security can be a star performer, only to severely underperform the very next year.
This is why having a range of assets is usually a sensible option. If one asset class performs favourably, it can potentially offset another that is performing less favourably, providing more balance to your portfolio when market shifts occur. There are four main types of investment, known as ‘asset classes’. These include:
- Equities (stocks)
- Fixed-income and debt (bonds)
- Money market and cash equivalents
- Real estate and tangible assets
Though it cannot guarantee against losses, having a diversified investment portfolio is vital to minimising risk. As well as investing across asset classes, you can further diversify by spreading your investments within asset classes. For instance, corporate bonds and government bonds can offer very different propositions; the former tends to offer higher possible returns but with a higher risk of defaults.
However, although you can diversify within one asset class – for instance, by holding shares (or equities) in several companies that operate in different sectors – this will fail to insulate you from systemic risks, such as international stock market volatility. Each asset class has different characteristics and advantages and disadvantages for investors. Investment returns vary significantly between asset classes, year to year.
Resisting the temptation to change your portfolio in response to short-term market movement can be difficult. But ‘timing’ the markets seldom works in practice and can make it too easy to miss out on any gains.
The golden rule to investing is allowing your investments sufficient time to achieve their potential. Over the long term, investors will experience market falls which happen periodically. Generally, the wrong thing to do when markets fall by a reasonable margin is to panic and sell out of the market – this just means you have taken the loss. It’s important to remember why you’re invested in the first place and make sure that rationale hasn’t changed.
Seeking professional advice
Under normal market conditions, diversification is an effective way to reduce risk. Though it’s worth remembering that different investors are at different stages in their lives. Younger investors may have a longer time horizon for making investments than older investors. Risk tolerance is a personal choice, but it’s good to keep perspective on personal time horizons and manage risk according to when access to funds from different assets is needed.
At George Square Financial Management, we provide comprehensive, creative investment advice to individuals, trusts, families, charities and businesses. We can analyse your existing portfolio and assess how it can best be optimised, restructured or better managed – often in a more tax efficient or cost effective manner.