Spreading risk between different kinds of investments
When you start investing, or even if you are a sophisticated investor, one of the most important tools available is diversification. Whether the market is bullish or bearish, maintaining a diversified portfolio is essential to any long-term investment strategy.
Diversification allows an investor to spread risk between different kinds of investments (called ‘asset classes’) to potentially improve investment returns. This helps reduce the risk of the overall investments (referred to as a ‘portfolio’) under-performing or losing money.
With some careful investment planning and an understanding of how various asset classes work together, a properly diversified portfolio provides investors with an effective tool for reducing risk and volatility without necessarily giving up returns.
If you have a lot of cash – more than six months’ worth of living expenses – you might consider putting some of that excess into investments like shares and fixed interest securities, especially if you’re looking to invest your money for at least five years and are unlikely to require access to your capital during that time.
If you’re heavily invested in a single company’s shares – perhaps your employer – start looking for ways to add diversification.
Diversifying within an asset class
There are many opportunities for diversification, even within a single kind of investment.
For example, with shares, you could spread your investments between:
Large and small companies
The UK and overseas markets
Different sectors (industrial, financial, oil, etc.)
Different sectors of the economy
Diversification within each asset class is the key to a successful, balanced portfolio. You need to find assets that work well with each other. True diversification means having your money in as many different sectors of the economy as possible.
With shares, for example, you don’t want to invest exclusively in big established companies or small start-ups. You want a little bit of both (and something in between, too). Mostly, you don’t want to restrict your investments to related or correlated industries. An example might be car manufacturing and steel. The problem is that if one industry goes down, so will the other.
With bonds, you also don’t want to buy too much of the same thing. Instead, you’ll want to buy bonds with different maturity dates, interest rates and credit ratings.
[1] Cash you put into UK banks or building societies (that are authorised by the Prudential Regulation Authority) is protected by the Financial Services Compensation Scheme (FSCS). The FSCS savings protection limit is £85,000 (or £170,000 for joint accounts) per authorised firm.
