Reducing investment risk through diversification
Written by Adam Kemp on May 09, 2016.
There is no getting away from the fact that investing inherently involves risk. Anyone who claims to be offering you a risk-free investment is lying and also taking you for a fool. Investment risk can seem elevated during periods when the markets are volatile, like now, however there that doesn’t mean that you should cash in all your investments and hide all your money in the biscuit tin. After all, it’s still at risk there - it could be lost, stolen, damaged and/or lose value due to inflation.
Yes, investing carries a degree of risk but there is a very simple way of protecting your investments and that is through diversification. This simply means creating a portfolio which is balanced across different asset classes.
Investors hold assets as cash, equities, bonds, properties and commodities and a balanced portfolio will be invested across these different asset classes so when one of them is hit by difficult economic conditions others will be doing better. Diversified investing allows better performing assets to counterbalance the underperforming ones.
You might be surprised to see just how wildly performance of different asset classes can vary over a short period of time. Today’s top performer can often be tomorrow’s turkey and vice versa. Take gold as an example. In August last year gold was having a tough time of it with the financial pages full of tales of its woes. Bloomberg.com told us Gold Prices Sink to a 5-Year Low and the Macquarie Group claimed that ‘Gold has no appeal as a commodity’. Fast forward to early 2016 when volatility has well and truly hit the markets and suddenly gold is starting to sparkle again – an article in Business Insider UK this week is headlined simply ‘Gold is surging’. That’s a huge turnaround in the space of 9 months. Meanwhile, shares were following a very different path. As this graph of the FTSE 100 index shows, share prices were on a downward trajectory for the second half of 2015 hitting a low in February this year (but seem now to be moving slowly back up).
Investors can diversify still further within each asset class. For example, property investors may choose to have a portfolio which contains both residential and commercial property, or buy-to-let apartments in different cities or even countries, or the equity part of a portfolio may be invested in different industries and geographical areas.
How much risk you are willing to take is called your risk tolerance. Any decent financial adviser will take this into account when working out your financial plan. Your risk tolerance will be affected by various factors including your age, how close you are to retirement, your family situation and your personality. For example those with a long investment horizon can afford to take greater amount of risks – with the potential for greater rewards but also greater losses – than someone looking with more pressing investment goals.
If you would like some help in putting together a diversified portfolio which is tailored to your unique requirements in terms of goals, investment timescale and attitude to risk, I’d be delighted to hear from you.