DIVERSIFICATION AND RISK
All investments carry some element of risk. The value of the fund can fall as well as rise and you may not get back the full amount originally invested. To enable funds to be able to manage risk, the manager will practice some level of diversification. This works on the premise that holding two different shares is better than two of the same shares. This is because all shares react differently to investment conditions and changes.
When you start investing, or even if you are a sophisticated investor, one of the most important tools available is diversification. Whether the market is bullish or bearish, maintaining a diversified portfolio is essential to any long-term investment strategy.
Diversification allows an investor to spread risk between different kinds of investments, called ‘asset classes’, to potentially improve investment returns. This helps reduce the risk of the overall investments, referred to as a ‘portfolio’, under-performing or losing money.
With some careful investment planning and an understanding of how various asset classes work together, a properly diversified portfolio provides investors with an effective tool for reducing risk and volatility without necessarily giving up returns.
If you have a lot of cash – more than six months’ worth of living expenses – you might consider putting some of that excess into investments like shares and fixed interest securities, especially if you’re looking to invest your money for at least five years and are unlikely to require access to your capital during that time.
If you’re heavily invested in a single company’s shares – perhaps your employer – start looking for ways to add diversification.
Diversifying within an asset class
There are many opportunities for diversification, even within a single kind of investment. For example, with shares, you could spread your investments between:
- Large and small companies
- The UK and overseas markets
- Different sectors (industrial, financial, oil, etc.)
Different sectors of the economy
Diversification within each asset class is the key to a successful, balanced portfolio. You need to find assets that work well with each other. True diversification means having your money in as many different sectors of the economy as possible.
With shares, for example, you don’t want to invest exclusively in big established companies or small start-ups. You want a little bit of both (and something in between, too). Mostly, you don’t want to restrict your investments to related or correlated industries. An example might be car manufacturing and steel. The problem is that if one industry goes down, so will the other. With bonds, you also don’t want to buy too much of the same thing. Instead, you’ll want to buy bonds with different maturity dates, interest rates and credit ratings.
Informed decisions to improve your chances of achieving your financial goals. If you want to plan for your financial future, it helps to understand risk. If you understand the risks associated with investing and you know how much risk you are comfortable taking, you can make informed decisions and improve your chances of achieving your goals. Risk is the possibility of losing some or all of your original investment. Often, higher risk investments offer the chance of greater returns, but there’s also more chance of losing money.
Risk means different things to different people. How you feel about it depends on your individual circumstances and even your personality. Your investment goals and timescales will also influence how much risk you’re willing to take. What you come out with is your ‘risk profile’.
Different types of investments
None of us like to take risks with our savings, but the reality is there’s no such thing as a ‘no risk’ investment. You’re always taking on some risk when you invest, but the amount varies between different types of investment.
As a general rule, the more risk you’re prepared to take, the greater returns or losses you could stand to make. Risk varies between the different types of investment. For example, funds that hold bonds tend to be less risky than those that hold shares/equities, but there are always exceptions.
Losing value in real terms
Money you place in secure deposits, such as savings accounts, risks losing value in real terms (buying power) over time. This is because the interest rate paid won’t always keep up with rising prices (inflation). On the other hand, index-linked investments that follow the rate of inflation don’t always follow market interest rates. This means that if inflation falls, you could earn less in interest than you expected.
Inflation and interest rates over time
Stock market investments might beat inflation and interest rates over time, but you run the risk that prices might be low at the time you need to sell. This could result in a poor return or, if prices are lower than when you bought, losing money. You can’t escape risk completely, but you can manage it by investing for the long term in a range of different things, which is called ‘diversification’.
You can also look at paying money into your investments regularly, rather than all in one go. This can help smooth out the highs and lows and cut the risk of making big losses.
Capital risk
Your investments can go down in value, and you may not get back what you invested. Investing in the stock market is normally through shares (equities), either directly or via a fund. The stock market will fluctuate in value every day, sometimes by large amounts. You could lose some or all of your money depending on the company or companies you have bought. Other assets such as property and bonds can also fall in value.
Inflation risk
The purchasing power of your savings declines. Even if your investment increases in value, you may not be making money in ‘real’ terms if the things that you want to buy with the money have increased in price faster than your investment. Cash deposits with low returns may expose you to inflation risk.
Credit risk
Credit risk is the risk of not achieving a financial reward due to a borrower’s failure to repay a loan or otherwise to meet a contractual obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.
Liquidity risk
You are unable to access your money when you want to. Liquidity can be a real risk if you hold assets such as property directly and also in the ‘bond’ market, where the pool of people who want to buy and sell bonds can ‘dry up’.
Currency risk
You lose money due to fluctuating exchange rates.
Interest rate risk
Changes to interest rates affect your returns on savings and investments. Even with a fixed rate, the interest rates in the market may fall below or rise above the fixed rate, affecting your returns relative to rates available elsewhere. Interest rate risk is a particular risk for bondholders.
The value of investments may fall as well as rise. You may get back less than you originally invested.
And finally ….
ARE YOU PLANNING FOR THE LIFE YOU WANT?
Having a clear financial plan linked to your lifestyle goals is essential, whether this is working out ways to build an investment portfolio, set up a business, retire early or leave your wealth to your family. Premier Wealth Solutions Ltd will ensure that your strategy encompasses an overall total wealth solution so you can plan for the life you want. For more information, or to discuss how we could assist you, please contact us.