The single most important concept for every investor
Contributor: Rebecca O'Keeffe | Interactive Investor
The clamour of markets and the jargon that comes with it can sometimes make investing appear more complicated than it is.
Diversification, it is essential
The fundamentals of investing never really change, even as the world evolves and challenges and opportunities come and go. At the heart of it all is a simple concept that might be the single most important one for any investor to grasp – diversification.
This is the investment version of making sure you do not have all your eggs in the one basket. It is the most effective way of managing the risks we take when investing; getting it right is a very big part of any successful investment journey.
This is never more true than in times of market stress. Even when global markets can seem irrational, it is still the case that having exposure to different segments of the market mean that you are not exposed to too great a risk in any one part of the market.
Diversification has a role in every portfolio because, after all, there is no such thing as a risk-free investment.
In addition to diversification, all investors have to come to terms with the risk-reward trade-off: the more risk you take, the higher the potential returns (if things go your way) and the higher the potential losses (if they do not). Conversely, the less risk you take, the lower the potential returns and losses.
Diversification and your portfolio
Done properly, diversification helps ensure your investment portfolio is built and maintained in a way that meets your needs while reflecting your risk appetite. It typically involves investing in a mix of different assets.
This starts with the main building blocks – equities (both large and small-cap stocks), bonds, cash, and property – as well as some alternative investments, while there will be degrees of diversification within the different asset classes too.
Diversification should also extend to different geographic areas, including Western and established Eastern economies as well as emerging economies.
Holding different investment products can also give you a better portfolio, so don’t overlook the opportunity to invest in funds, shares, investment trusts and exchange-traded funds (ETFs), all of which give you wider diversification and a better chance of delivering optimum returns.
What constitutes a well-diversified portfolio will in part depend on the kind of investor you are, your personal circumstances, objectives, needs and attitude to risk.
For one person it might mean relatively high-risk investments spread across different stock market sectors and regions. For another it might mean holding a broad portfolio of corporate and government debt.
But what is true for both risk-loving and risk-averse investors is that more diversification will always improve your expected returns relative to the amount of risk you are happy to take.
An ultra-cautious investor is likely to have a portfolio made up primarily of lower risk assets such as cash and certain types of government and corporate bonds.
Someone at the other end of the scale is more likely to have most of their money in equities, including exposure to higher risk categories such as emerging markets, specialist sectors and smaller companies.
In reality, most investors will probably lie somewhere between the two. In which case, it’s about getting the mix of different assets right.
All of this underlines the importance of understanding the level of risk you’re comfortable taking.
Your risk appetite is the level of risk you can tolerate, not just emotionally but also relative to your financial circumstances and the length of your investment horizon.
A portfolio that’s mostly invested in equities might keep you awake at night, but if you are a young person saving towards your pension, there should be a number of decades before you need access to your cash, and what appear to be sharp movements in markets now will, eventually, show up as mere blips in a longer-term trend.
There is a balance to be struck here. There is also a risk of ‘reckless caution’ – if you take too little risk you may never achieve the long-term goals you’ve set.
The good news is that while professional financial advice is always recommended, there are numerous other resources available to those who are unable or unwilling to take the advised route.
For example, it is possible to access various forms of online risk-appetite tools, questionnaires and portfolio builders, as well as calculators, information and up-to-date commentary.
Keeping it on track
Making sure your investments are diversified isn’t a once-and-done job. There are several reasons why it’s well worth reviewing your position on a regular basis, including what’s sometimes referred to as ‘portfolio drift’. This is where the mix of investments can change over time as a result of developments such as stock market ups and downs.
For instance, when equity markets go up in value, so too will the part of a portfolio that’s invested in stocks, leaving you with a portfolio that may have more invested in equities than you intended.
The reverse process can happen when markets go down too, potentially resulting in a portfolio that no longer matches your appetite for risk and which might not be in line with your long-term goals or circumstances.
A portfolio review can make all the difference when it comes to getting what you need from your investments, even if you only do it once a year (at tax-year end, for example).
Or you could be more proactive and take a look under the bonnet of your portfolio on a more regular basis, eg during or after significant market moves.
The review may lead to what’s known as portfolio rebalancing – making the necessary changes to make sure your investments are still doing what you want them to, continue to reflect your risk appetite and remain sufficiently diversified.
Effective diversification is the thread that runs through every successful long-term portfolio.
Whatever’s happening in your life, in stock markets and the wider economy, it’s the investment principle that helps give peace of mind while getting the best out of your money.