Why portfolio diversification matters
Portfolio diversification is meant to minimise the risk that you could lose all your money. There is not a single investment option in the world that is entirely risk free – bonds can default, banks can collapse and stock market investments can underperform. By keeping all of your money in just one or two asset classes, you leave yourself vulnerable to any unexpected events. By spreading your money across an array of different asset classes, you can dramatically reduce this risk.
Mastering portfolio diversification is not as simple as investing your money in as many places as possible. Whether you are investing in stocks, shares, bonds, or funds, each transaction incurs a fee. An over-abundance of fees can quickly add up to cancel out any returns that you might otherwise make.
In order to protect your investments from volatility, you first need to create a portfolio diversification strategy. For first time investors, this might seem daunting, but there are a few tricks and tips that can help any type of investor to master portfolio diversification in 2018 and beyond.
How to diversify your portfolio
1. Invest via funds
Funds offer instant diversification, by spreading your investment across a range of stocks and shares which are all linked by a common theme. If you have an interest in one particular sector or geography, a dedicated investment fund is a great way to introduce your money to new areas without taking on too much risk.
For instance, an emerging markets-themed fund is likely to invest only in countries such as Brazil, India, and Russia, which are classified as having ‘emerging’ economies. Meanwhile, tech-focused funds are likely to invest in companies such as Apple and Tesla.
Recently, there has been a surge in the popularity of multi-asset funds, which invest across a ready-made diverse portfolio on the investor’s behalf. According to a recent count by FTAdviser, there are at least 11,266 multi-asset funds on sale to retail investors in the UK - more than 8000 of which have been launched since 2013. These figures underscore the importance of portfolio diversification for many UK investors, who are prepared to pay steep management fees for the ease of investing in a professionally-handled fund.
Exchange traded funds (ETF) can help to keep costs down by automating the investment process, and cutting out the middleman. ETFs work by tracking certain indices and sectors and mirroring those returns. This allows retail investors to access a variety of different sectors and assets at once, for a nominal fee of less than 1%.
2. Create a balanced portfolio
Traditionally, a ‘balanced’ portfolio refers to a portfolio which is largely split between equities and bonds, with a small amount of money held in cash. Equities are considered a riskier investment option, as their performance is so dependent on the movements of the stock market (although there is the potential for strong gains over time). Bonds, on the other hand, tend to be extremely low risk, and pay out a fixed amount of interest over a certain term.
By combining the high risk, high reward potential of equities with the slow and steady promise of bonds, you can create balance in your portfolio and aim for returns that are a little better than cash or bond yields alone.
Getting the right portfolio balance can take some time. For very conservative investors, a balanced portfolio might include 25% in cash holdings, 55% in bonds, and as little as 20% in equities. A more moderate investor might keep just 10% in cash, with the remaining 90% split evenly between equities and bonds. And an aggressive investor may prefer to place upwards of 80% in equities, 15% in bonds and just 5% in cash.
Regardless of how you choose to split your allocations, by prioritising balance in your portfolio you help ensure a base level of diversification that will protect you from being overly exposed to any one type of investment.
3. Review your portfolio regularly
As your portfolio matures, you will find that your risk appetite or investment goals change significantly. For instance, as you draw closer to retirement, you may prefer to reduce your exposure to the equities market and focus on fixed income investments instead.
Similarly, you might anticipate an upcoming change in your financial circumstances by moving some of your long-term bond investments into a more liquid asset class such as FTSE 100 stocks and shares.
Over time, you may even find that a new asset class emerges that you are keen to invest in. For instance, over the past few years cryptocurrency, peer-to-peer lending and crowdfunding have dominated the alternative investment space, inspiring investors to carve out some room in their portfolios to gain access to these new sectors.
Diversification can take many different forms, so don’t be afraid to switch up your allocations every few years, or even every few months. Set regular review dates, and use this time to sift through your portfolio and ensure that you are still comfortable with the performance of your money, and the amount of risk that you have taken on. And with a little trial and error, you can build your confidence and create a diversified portfolio that delivers increased security and strong returns.