If recent history has taught us one thing it’s that there are only so many things we can control. So, in an uncertain environment it becomes even more important to understand ways of managing risks in case the unexpected happens.
Putting all your investment (nest) eggs in one basket can be risky. Instead, spreading your investments across different products and areas makes you less dependent on any one pick to perform for you.
This is diversification – choosing different kinds of investments across a range of markets that don’t rely on the same things to do well at any one time. By diversifying your investments, you can smooth out the effects of one performing badly, while still reaping rewards when others do well.
How to make diversification work for you, come rain or shine
Imagine buying and running an ice cream van. Sales are great on nice days – you’re rushed off your feet, people are queuing up for ice cream when the weather’s hot and sunny. So far so good.
But, when the weather takes a turn for the worse, your outlook’s not so sunny either. When it’s raining people aren’t so keen on ice cream, they’re more interested in staying dry. Rather than looking for ice cream when it’s raining, they’re thinking more of umbrellas.
So if you’re set up to sell umbrellas on wet days and ice cream on sunny days you’re more likely to have steady overall sales, whatever the weather. By diversifying across 2 markets you’ve made your business more resilient to changes in something you can’t control – the weather.
Diversification in practice with a £1,000 pot
Imagine you have £1,000 to invest – let’s look at 3 possible options:
1. No diversification whatsoever
Buy shares in one single company
Perhaps you’ve done some research, or maybe somebody’s given you a tip. Or you’re just acting on gut feel. Whatever your motivation, you decide to pile the lot into one company’s shares. It could go well, it might go badly, with the shares possibly up or down by 20% a year later. Either way, your investment performance is totally reliant on the share price of one single company.
2. Some diversification
Buy a portfolio of UK shares, spread across different companies
You are happy to invest into the stock market but don’t want your investment to be dependent on the share price of any single company. So you spread your investment across a range of shares, ideally across companies in different business sectors, like retailers and engineering companies. By diversifying across the UK stock market you can protect yourself in case any one sector struggles. This way, your £1,000 investment’s performance is linked to the returns from a basket of shares, rather than just one company’s.
3. Full diversification
Holding diversified investments spread across different markets
You go one step further, spreading your investments beyond just the UK stock market. So you keep some cash and buy some bonds, possibly adding a fund that invests in shares from international markets, such as elsewhere in Europe, the US and Japan. This would spread your risk so that overall performance is smoothed out across several different types of investment.
How you can benefit from diversification
In the real world, making the perfect decision every time is impossible.
When investing, making your choice from a range of different options reduces your reliance on any particular one working out well. By diversifying, you can dilute the overall effect of any single investment performing badly.
In the the above examples, spreading your investment across different markets reduces overall risks and helps to smooth out returns over the longer term.
There will always be individual instances where diversification might not pay off in the short term. In the £1,000 investment example above, it could be that the first option – the single company one – performs as strongly as the second and third examples. But the single company shares could just as easily drop on bad news.
It’s also worth noting that spreading your investments across different types of assets can protect you from short-term market swings. It can help you to find the right balance of risks and opportunities, and smooth out returns over time.
Diversifying when you’re new to investing
Whether you’re just getting started by investing small sums, or already have a sizeable investment pot, you can still benefit from diversification.
For example, investors large or small can choose to diversify their investments through the use of funds, which combine money from many different investors into one pool which can then be invested for them. Some funds invest in a range of company shares from a stock market in one single country, like the UK or the US, while others buy a mix of shares in companies from all across the world.
Meanwhile, other funds invest only in bonds (a kind of loan made by investors to governments or companies) or make investments in areas such as precious metals or property. Some funds hold a combination of shares, bonds and other kinds of assets, also spreading investments across a range of different countries to offer investors as much diversification as they can.
For more experienced investors who are prepared to take more risk in search of higher potential returns, a good rule of thumb is to limit any exposure to high-risk investments to only 10% of your portfolio.
If in doubt, an independent financial adviser can help you understand the options available and tell you more about the benefits of diversifying your investments.
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