The benefits of diversification

Posted on June 11th, 2020 | Categories - News

Over the past few months, stock market volatility has never been far from the headlines. At Investment Sense, we’ve been quick to offer reassurance and a clear ‘don’t panic’ message.

Your investment portfolio is designed to withstand the pressures of a short, sharp shock to the market. By remaining calm, avoiding knee-jerk reactions, and keeping your money invested, you stand the best chance of reaping the rewards of a market recovery, achieving good returns in the long term.

One method employed to help your portfolio weather periods of economic uncertainty is diversification. The recent effect of coronavirus on the markets has highlighted its importance.

But what do we mean when we talk about a diversified investment portfolio?

What is diversification?

Diversification means spreading investment risk. Or put another way, not having all your eggs in one basket.

Having a diversified portfolio means investing in different asset classes with different levels of risk. It is also likely to mean investing across a range of different industries and sectors, in different parts of the world.

Spreading risk lessens the impact of a fall in one area, whether that’s a region, an industry, or an asset class. It is hoped that a fall in one area will be offset by better performance in another.

It is diversification that explains why a fall in the FTSE 100 of a given percentage, is unlikely to equate to an equal drop in your investment value.

Broadly speaking, there are four asset classes.

  • Equities – When you buy equities, you are buying a share in a public limited company. You will potentially make money from a rise in share price and this gain will often be paid back to you as a dividend. Shares are considered a high-risk asset class as share prices can fall as well as rise.
  • Bonds – Bonds are effectively a loan. You loan an amount to the company from whom you buy the bonds, and in turn, you receive interest payments on the loan. Bonds are perceived to be lower risk, typically offering lower returns in the long term.
  • Property – Property, along with other tangible assets such as gold and livestock, forms its own asset class.
  • Cash – As the lowest-risk asset class, returns on cash investments tend to be lower too. Cash investments might be most suitable for the risk-averse, and those not looking for long-term growth.

The benefits of diversification

1. Minimising risk

As demonstrated so far this year, markets generally respond badly to uncertainty. So-called ‘noise’ can impact on prices and have a short-term negative impact on investments.

With a diversified portfolio, if one asset class performs poorly, it can be hoped that another performs less so, helping to offset the loss. The same is true geographically and within different industries.

FTAdviser reports that as of 1st April 2020, global equities had fallen 25% but that ‘multi-asset funds have held up well’. ‘Government bonds,’ the report continues, ‘have done best in the current scenario’.

Elsewhere, The Guardian quotes a recent report from US investment management firm, Black Rock, suggesting companies with better records on environmental, social and governance (ESG) issues fared slightly better in the year to 30 April 2020. They report that ‘88% of sustainable funds lost less than their non-sustainable counterparts.’

2. Consolidating gains already made

There may come a point when you are no longer in an accumulation phase of investment. This might happen when you get close to retirement.

At this point, as a life milestone nears, you’ll want to consolidate the gains you have already made. A riskier strategy heavily weighted toward one asset class or geographical region could result in a large loss. This would be hard to recoup in the short amount of time left before your retirement and could see you retire with investments at a loss.

3. Increased chance of generating returns

Over-reliance on one asset class puts pressure on that class. High performance in a given area could result in large gains but could equally mean big losses too.

The previously mentioned FTAdviser article confirms that a portfolio invested solely in equities could’ve suffered a 25% fall to April this year. Once the stock market begins to recover certain asset classes may recover more quickly.

Diversifying means spreading the risk, but also the possibility of reward, by not being reliant on only one asset class, region, or sector as a source of possible income.

4. Limits regional bias

We’ve already seen that part of diversification involves a wide geographical spread. This is useful because it helps to alleviate ‘home country bias’. This is an investor’s natural tendency to favour investment opportunities in local enterprises.

A diversified portfolio will look beyond domestic companies, seeking opportunities all over the world.

5. Provides greater opportunity

By not being constrained by industry, regional, or asset class restrictions, a diversified portfolio can invest widely, hopefully seeking out the areas where lucrative gains might be had, whilst spreading the chance of loss through the inclusion of lower-risk investments.

Get in touch

Diversification is an important part of your investment portfolio. It helps to spread investment risk, allowing your funds to ride the temporary storms of market volatility, and give you the best chance of achieving large returns in the long term.

If you’d like to discuss any aspect of your investments, get in touch. Please email info@investmentsense.co.uk or call 0115 933 8433.

Please note:

The value of your investment (and any income from them) can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance. Investments should be regarded over the longer term and should fit in with your overall attitude to risk and financial circumstances.

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