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Diversification refers to the practice of allocating capital (e.g. money) to different investments and to different asset types within an investment portfolio. This may include investing not only in multiple companies from different sectors, industries and countries, but also in non-equity-based investments such as UK Government bonds (gilts) and commercial property. Yet why diversify a portfolio, and how do you do so effectively? Below, our financial planning team at WMM offers some answers to these questions which you can consider in discussions with your own adviser.
Why diversify?
Suppose you had £10,000 to invest and you put all of it into Facebook stock (worth about $306 at the time of writing). Given the company’s success over the years, you might think this to be a great investment. Yet putting all of your money into one company stock is very risky. What if the company fails, or the stock plummets in value and remains low for decades? At this point, you are likely to want to sell and crystallise a huge loss – maybe the whole value of your investment.
Diversifying your money, however, helps to shield it from this outcome. Imagine you spread the £10,000 across 200 companies, for instance. If 1, 5 or even 10 of them fail, this should not harm your portfolio significantly since many of the other investments are likely to have held steady or risen in value during this time. As such, even if some of your equity investments fail in a given timeframe, others can help to continue carrying your portfolio towards your financial goals.
How to diversify
Diversification is not a simple process, however. It takes great skill, experience, knowledge and discipline to craft a viable asset allocation strategy – and stick to it over the long term. Just take a look at The Telegraph’s Fantasy Fund Manager game. Here, you can try your hand at “stock picking” with imaginary money, and you can see for yourself how hard it is to pick winners within a short timeframe. A financial planner can help you move away from this “trading mindset” and build a portfolio which reflects your goals, risk appetite and investment horizon.
Regardless of these three factors, however, all portfolios will need to consider the following. The first is to include a range of different investments (even if the balance may vary compared to others’ portfolios). If you are a “cautious” investor, for instance, then it likely isn’t a good idea to simply put all of your money into UK Government bonds (gilts). Instead, you may benefit from also including some long-term corporate bonds, as well as some lower-risk equities. If you are a more “aggressive” investor with a longer investment horizon, on the other hand, then be careful not to simply focus your money on tech shares, or another “corner” of the equity market. Rather, consider spreading capital across different sectors and markets to access opportunities outside of your niche interest, and to help keep your portfolio growing if any given sector declines.
It will also be important to rebalance your portfolio occasionally. Here, you need to be careful. If you constantly tinker with your investments – i.e. making regular trades – you are likely to erode your returns by racking up transaction costs, and also risk your strategy by slipping into “short term” investment tactics (e.g. timing the market). At the other extreme, you want to avoid simply leaving your portfolio unattended. This will likely see your asset allocation skew off-balance as different aspects of your portfolio perform differently over the years. A financial planner can help you identify the right time to revisit your portfolio and rebalance appropriately.
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