Investment Diversification
Investment Diversification
WHAT IS INVESTMENT DIVERSIFICATION?
Investment diversification refers to the spreading of funds across various investments.
When you spread your funds across different companies, industries, risk profiles, asset classes and even geographic locations, you are spreading (or diversifying) your investment.
The combinations of these different types of investments make up the ‘investor’s portfolio’. If someone has a highly diversified investment portfolio, they will hold many different types of assets, if they aren’t well diversified, they will hold few different types of assets.
WHY IS IT IMPORTANT?
Diversification is essential to any portfolio because it spreads your risk. Think about if you invested your entire pension into one entity and it then got wiped out!
A well-diversified portfolio will include investments that react differently to the same economic event. This means that as one asset sector, or geographic region experiences poor returns, another experiences an increase: and you hold investments in both.
Another important aspect of diversifying your portfolio is that it creates a smoothing of returns and minimises your risk of major losses. You can still lose some (or all) of your investment of course, but generally the effects will be less than if you weren’t spreading your risk.
Diversification is also important in terms accessing your funds. If you are invested in only one, or a few types of investments (not very diversified), you may be reluctant to withdraw funds when they are performing badly as this will crystalise (realise/solidify) the loss. When you hold some assets that perform better when others are down, then you are less likely to have to wait to withdraw funds.
DOWNSIDE TO DIVERSIFICATION
One of the downsides to diversification is that it can be more expensive. Each time you invest you might incur brokerage fees. If you only invest in one or a few assets then you pay these fees less frequently, but the more assets you invest in, the more expensive it is likely to be.
Another downside is that you could miss out on higher returns if you weren’t spreading your investments. When you diversify your investments, you reduce the impact of the individual asset’s performance. If that asset goes down, this is good – the value doesn’t go down as much as it would have if all your funds were in this asset. However, this means that if the asset performs very well you will not reap all of the benefit you could have if you just held this investment.
Investment diversification is a trade-off. Yes, you may miss out on higher returns, but spreading your investment reduces volatility, risk, and stress.
*It is important to remember that whilst diversification lowers your risk and helps to create a better-balanced investment portfolio, it does not guarantee you won’t lose some or all your investment.
HOW TO DIVERSIFY
There are a few ways to help you diversify. Incorporating some/all of these can help to strengthen your portfolio’s ability to withstand the storms of market volatility.
So, when choosing your asset allocation, you should consider picking types of assets that react differently to economic events. This refers to the correlation between investments. If assets are positively correlated, they move in the same direction when reacting to economic events. If they are negatively correlated, they move in opposite directions to events; while neutrally correlation means they move independently when an event occurs.
Many people think investing is just exposure to stocks and bonds, but to create a fully diversified portfolio you could also consider a mix of:
- long term and short term assets
- money market assets
- mutual funds
- exposure to different sectors
- exposure to different economic regions
You should also consider:
- What is your risk profile/risk tolerance?
- How long can you afford to have these funds tied up?
- If you needed funds urgently and unexpectantly, do you have reserve funds?
The answers to these questions will affect how you should invest, where you should invest, and even if you should invest at all.
Lastly, no conversation about investment risk would be complete without mentioning ‘systematic risk’. It is important to understand that any investment in the stock market carries risk which cannot be completely diversified because investing in the stock market is inherently risky. As such, investment risk cannot be totally eliminated.
INVESTING WITH TOWN CLOSE FINANCIAL PLANNING
Deciding where to invest can be daunting – especially if you don’t have much experience. Fortunately, the Independent Financial Planners at TCFP carefully consider all the above (and more!) when investing your funds, so you don’t have to.
We liaise with economic experts about future forecasts and select a varied asset portfolio to ensure diversification. We do not ‘actively manage’ your investments so you don’t pay the big price tag that accompanies that label; however, we do rebalance investments occasionally when we spot an opportunity to better your investments position.
Importantly, before we even think of investing, we believe in getting to know you. This will help us better understand what is important to you, how much money you want in the future and what how much you have now. We’ll also discuss your ‘risk profile’, how much you should invest, how much to keep aside for any short term large purchases, and provide a cash flow forecast to cover the rest of your life.
All these aspects come together to determine how we can help you invest with us, with the goal of putting you in the best financial position possible.
What our clients say
“Jeremy help [sic] to organise our finances, especially, our pensions and investments in such a way that the returns we are seeing are better than best expectations. His experience, guidance and extremely professional and friendly manner means that this is someone we feel confident we can trust with our finances.”
Q: Have you seen the outcome you were hoping for?
“Yes, we have seen better than we had been hoping for. Investments had grown higher than industry norms and faster than our expectations” – West Essex client (Testimonial from Vouchedfor).
You can find many more client testimonials here.
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