Investing can be daunting, but one key strategy can help you manage risk: diversification.
By spreading your investments across different types of assets, you can create a resilient portfolio and plan for the future. Let's break down how this works.
Understand Investment Risk
Remember that whenever you're investing, your capital is at risk. The value of any investment can go up as well as down and you may not get back the amount that you originally invested.
Don’t put all your eggs in one basket
If you’re meeting with an Independent Financial Adviser, you may hear the term asset allocation when discussing investment and pension planning. A portfolio’s asset allocation is simply just what the portfolio is actually invested in.
For many, this means dividing investments among different categories, like cash assets, bonds, stocks, and potentially other assets like real estate. The aim is to balance risk and potential reward based on your personal financial goals, how much risk you’re willing to take, and how long you plan to invest.
The key things to think about when building a portfolio:
Risk Tolerance: How comfortable are you with ups and downs in your investment value?
Risk Capacity: Regardless of how “up for it” you are, would a potential loss significantly affect your financial wellbeing? If so, you must plan accordingly.
Investment Goals: Are you saving for retirement, a house, or something else?
Time Horizon: How long can you keep your money invested without needing it back?
What assets might you find in your portfolio?
1. Cash
Cash forms an important part of many investment portfolios, since it is highly liquid and enables transactions to take place without delay such as provider fees. It also reduces the overall volatility of the portfolio.
There are other cash-based assets that you might find as part of funds within your portfolio, including money market instruments. These include highly liquid short-term borrowing assets and are generally considered low-risk by professional investors, but the returns are usually low.
2. Bonds
Bonds are loans. These can be issued either by governments (referred to as Gilts in the case of the UK) or companies in exchange for regular interest payments. They carry different risks to stocks and are closely affected by central bank interest rates.
Bonds have some unique characteristics that can make them valuable for investors, and higher yield bonds can be more suitable for higher risk investors, as these carry more default risk than lower-yield government bonds.
3. Equities (Stocks)
Equities represent ownership in a company. They offer high potential returns but can be more volatile than the previous types of assets discussed.
Over the long term, equities can grow significantly and can provide a strong hedge against inflation (since most efficient companies will increase profits in line with inflation) but they also come with the risk of losing value alongside the higher volatility.
4. Property (Real Estate)
Property investments can be advantageous to hold in some portfolios as a means of generating more diversification. They can be made through direct ownership of commercial properties like office buildings and malls or through shares in property companies (for example, REITs - Real Estate Investment Trusts), which are easier to buy and sell than property itself.
Comparison:
Liquidity: Property shares are easier to buy and sell than actual properties, and provide exposure to the property sector as an asset class without carrying the same level of liquidity risk.
Management: Owning property requires managing it or hiring someone to do so, whereas REITs are managed by professionals.
Volatility: Property shares can be more volatile due to stock market fluctuations, while real property values change more slowly.
As an investor, am I directly investing in these assets?
Generally speaking – no. Most investors are putting their money into funds. The technical name for the most common type seen in most ISAs and Personal Pensions today is Open Ended Investment Company (OEIC, pronounced “Oyk”).
Investing in Open-Ended Investment Companies (OEICs) or funds is a great way to diversify without having to pick individual assets. These funds pool money from many investors to buy a wide range of investments. This way, you can get exposure to a variety of assets without needing a lot of money or expertise.
Types of Funds:
Equity Funds: Invest primarily in stocks.
Bond Funds: Focus on bonds.
Balanced Funds: Combine stocks and bonds to balance risk and reward.
Property Funds: Invest in real estate, either through property shares or direct ownership.
As a firm of Independent Financial Advisers, we don’t spend our time managing these assets on a day-to-day basis. We focus on broad big-picture strategies for investors and keeping things simple so that we can focus our resources on your personalised financial plan.
How Diversification Works
Diversification asset-specific reduces risk by spreading your investments across different assets. This means if one type of investment performs poorly, others might perform well, balancing out overall returns.
Why you should diversify
The S&P 500 Index includes 500 large companies in the U.S. Historically is has grown very well over time but can be very volatile, with big ups and downs.
Gold, on the other hand, has been seen as a safe investment during tough economic times. However, gold can also go through long periods where it doesn’t grow much or even loses value.
If an investor had £100,000 available to invest in 1980, and they only invested in the US Stock Market, they would have gained over £1,000,000 by 2000. In contrast, Gold fell by 45% over the same period.
Whilst the S&P 500 Index and Gold are not directly comparable, this example does illustrate the need to diversify across asset types. By investing across multiple assets, potential downsides can be mitigated.
Geographical Diversification
Investing across different regions and countries works similarly – exposing investors to a diverse range of opportunities whilst mitigating the impact of potential losses, since different economies often perform differently at various times.
By diversifying geographically, investors can protect their portfolios from economic downturns in any single region.
Diversification is just one aspect of financial planning
Building a resilient investment portfolio is all about diversification. By spreading your investments across different asset types and regions, you can manage risk and improve your chances of steady, long-term growth.
Diversification is not just a strategy; it’s essential for anyone serious about investing wisely.
For a truly risk-managed approach to diversified investments and pension planning, get in touch with us at BlackBear Financial Group.
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