Diversification is a frequently used term in the investment world, but what does it mean, how do we implement it, and why is it important?
In this guide, we explore what diversification means, and why it could make all the difference to your returns during periods of market turbulence.
What is Diversification?
A diversified portfolio holds a wide variety of different investments across a range of asset classes, world regions, and business sectors.
There are two main benefits to holding a diverse portfolio.
Firstly, it can help to avoid exposing your portfolio to too much risk in any one area. If you only invest in UK equities and the UK market drops, you are fully exposed to this risk. On the other hand, if you invest in a range of other markets as well, it is likely that some of the loss will be offset.
Secondly, investments will often behave differently depending on the market conditions, and will rise and fall at different times. Investing across a range of assets can help to smooth out some of the short-term bumps while ensuring you benefit from the overall growth in the market.
The Main Asset Classes
There are four main asset classes, which all have their own characteristics and purpose in a portfolio.
Cash is a stable asset, meaning that the value does not fluctuate. However, interest rates are generally behind the rate of inflation, which means that cash deposits are unlikely to hold their value in real terms.
The main use of cash within a portfolio is to provide liquidity and avoid volatility on money that will be required in the short-term.
A bond, or fixed interest security, is a loan to a company or government. Investors receive interest on their loan, and typically the higher the risk, the higher the interest rate.
This is complicated by the fact that bonds are bought and sold, both directly and within funds. While the interest rate is fixed, the market price of the investment will fluctuate with supply and demand.
Bonds carry more risk than cash, but are more likely to retain their real value over the long term. They are typically less volatile than equities but are highly sensitive to inflation and interest rates. Many bond investors saw heavy losses in 2022 when interest rates were rising quickly.
Bonds can be used to diversify against equities, as they do not always move in the same direction. They can also be used to generate an income.
Property is an investment that most people understand, as a tangible asset lies behind the valuation.
In terms of growth potential, property sits somewhere between bonds and equities. Property benefits both from capital growth and an income yield in the form of rental. It is another diversifier against equities, although in some cases the two asset classes do move in the same direction.
In most conditions, the value of a property fund will be more stable than a share portfolio. Property does have additional risks related to liquidity – if too many investors request withdrawals, some of the underlying property needs to be sold. This can either lead to delays or an accelerating drop in value, as more assets are sold to meet demand.
In buying equities, you purchase a share of a company and are entitled to a proportion of the profits (dividends). The value of the shares will fluctuate depending on the performance of the company, but more importantly, the market perception of the company. Supply and demand means that the share price is not always reflective of the company’s potential – shares can easily become over- or undervalued.
In general, equity prices have risen more quickly than other asset classes. This is compounded if dividends are re-invested by buying more shares. While equities provide the highest growth potential, they are also more volatile, and may lose money in the short term.
It is important to invest across all of the asset classes to gain the benefits of each, while mitigating the risks.
Diversifying Within Asset Classes
Diversification doesn’t stop there. A client’s risk profile may indicate that 60% of their portfolio should be invested in shares, but it would not be sensible to hold this amount in single company, or even in a single country.
True diversification means seeking variations within each asset class. This can involve investing in a range of geographical areas, in different industry sectors, or in varying sized companies. It may also mean deeper investigation into the business type of each company to avoid too much correlation.
Lessons from History
When a type of asset appears to be performing well, it can be tempting to put more money in, even to the extent of excluding others.
The ‘tech bubble’ of the early 2000s was an extreme example of this. Because of the intense demand for this relatively new sector, share prices became artificially inflated and not a true reflection of the underlying companies. The bubble popped in spectacular fashion, with many investors suffering heavy losses. A diversified portfolio, while not completely immune, would not be impacted to the same extent.
The 2008 financial crisis was unusual, in that all asset classes were negatively impacted. But diversified portfolios were well positioned to recover their value, with the temporary volatility becoming a ‘blip’ on an otherwise upward trajectory.
Similarly, in the period following the pandemic, we have seen war, a cost-of-living crisis, and rapidly increasing interest rates. This has resulted in volatility across the market, particularly in the bond sector. It is too early to say how this situation will play out, but diversified portfolios are likely to be best placed to capture the recovery.
In hindsight, investors may regret not moving in and out of certain asset classes before a major event. But this is how the market works – we cannot predict which investments will rise and fall at a particular time. Switching in and out of funds as market sentiment fluctuates is likely to do more harm than good, as it’s virtually impossible to choose the right time.
Investing across the market not only means that you benefit from long-term growth, but helps to reduce the remorse and decision fatigue of trying to time the market.
What Does a Well-Diversified Portfolio Look Like?
A well-diversified portfolio will not only hold the four main asset classes, but will invest across the world and in various industry sectors. It will invest in small and large companies, in mature economies and emerging markets. Most importantly, it will be held for the long-term, throughout the ups and downs in the market.
When things are going well, the portfolio will make modest gains. While it may lose money during volatile periods, it will not be as exposed as a more homogenous basket of investments. The goal is a steady, long-term return.
While this may sound complicated, you can access a diversified portfolio by investing in a single multi-asset fund, a range of funds, or a managed portfolio. There is a solution for everyone, wherever they are in their investment journey.
Please do not hesitate to contact a member of the team if you would like to find out more about your investment options.
The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.
The content in this article was correct on 01/12/2023.
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