Why you Should Diversify your Investments
When it comes to investing, it pays to diversify. Unless you have crystal ball, there’s no way of knowing for certain how each of your investments will perform over the next twelve months, or five years. Market conditions that cause one asset category to do well often cause another asset category to have average or poor returns.
A well-diversified portfolio might include investments in different assets such as equities, bonds, property, commodities and, last but by no means least, cash. The benefits of holding all these different assets means that when for one or two of them are performing poorly, the other assets might be better positioned to do well. For example, when equity markets struggle, less risky assets such as bonds rise in value. You'll therefore reduce the risk that you'll lose money because of short-term volatility. In the longer term, your portfolio will have a better chance of meeting your investment objectives.
Getting your Asset Allocation RightAsset allocation simply means dividing your portfolio into different asset categories. Your allocation to each area is entirely up to you, but it will often be determined by your investment time horizon and your attitude towards risk.
Your investment time horizon is the length of time you expect to be investing before you withdraw your money. This could be months, years or even decades. Those with a long time horizon, say for example a 30 year old who is investing in a pension which they plan to take out when they are 60, may feel that the bulk of their assets should be in equities, with a smaller portion of bonds and even less cash. Equities are generally considered to be the best performing asset class over long time periods.
However, when your investment time horizon starts to shorten, your investment needs will change. You should then think about shifting the majority of your assets into less risky areas. As retirement approaches, you may want to protect the profits you’ve already earned by moving most of your portfolio into bonds and cash, and leaving a much smaller amount invested in equities.
Diversifying Within an Asset ClassWhen it comes to diversification, asset allocation is only the starting point. Once you have your asset allocation right, you will need to think about diversifying your investments further. If you have most of your assets held within equities, you will want to make sure that the equities you hold are varied enough so that if some of them underperform, the others you hold will be better placed to make returns.
The key is to identify investments or areas of the market that may perform differently under different market conditions, and to spread out your investments across different categories. For example, instead of investing your portion of equity assets in a single fund (say a UK larger companies fund), you should think about offsetting this with other investments (a smaller companies fund, or one that invests outside of the UK). For instance, a well-diversified portfolio might include large-company, small-company, and international equities as well as government bonds (Gilts) and different corporate bonds designed to mature at different times.
The Cost of DiversificationThe more varied and wide-reaching investments you hold, the more diversified your portfolio should be. Bear in mind though that by adding more investments to your portfolio you might have to pay additional management fees and setting up costs. Some funds do the diversification for you, by investing in companies throughout the world and in a variety of different sectors. But to make your portfolio fully diversified, you will want to invest in more than a single fund, and preferably with more than one fund provider.
Diversification is all about making sure you do not put all your eggs in one basket and means that you are preparing yourself for all eventualities. By spreading your money in a wide range of different assets, sectors and even countries, you can give yourself greater protection should markets take a tumble.