Investing can be an incredibly risky business if you do not know what you are doing.
The story of a Chinese farmer who invested his life savings in a local mining company illustrates the point perfectly. He lost $164,000 when the company failed. Not only that, but he went into debt to buy $1 million more stocks to recoup his losses.
Most of us can see the problem here and think we would never do something so foolish as to put all of our eggs in one basket. Yet many people do make investment mistakes, sometimes against their better judgement and sometimes without realising it.
This is where a diversified portfolio can help protect your wealth. By spreading your money across multiple asset classes and investment types, you can mitigate your losses whilst maintaining a steady level of growth over the long term.
Diversification: An Example
The 2008 financial crisis might seem long ago to some people. For many investors, however, the pain is still fresh. Some people lost as much as 30% of their portfolio value in one year.
Yet this period of recent history provides a valuable lesson about the importance of diversifying your investments. Those investors with bonds in their portfolios, for instance, fared the storm much better than those with fewer bond investments and higher levels of (UK) equities.
Some portfolios with over 60% (UK) equities lost over 20% of the value of their portfolio between the end of 2007 and the beginning of 2009. Those with over 60% bonds might have only made a minimal loss – or even none at all.
The point here is not to try and argue that it is better to invest in bonds rather than stocks. Remember, past performance is no guarantee of future returns. Also, each investment type brings its own potential risks and rewards. Stocks tend to be higher risk with higher potential return, whilst bonds tend to carry lower risk and lower potential return.
Rather, the point is to show the importance of diversifying your investment portfolio. Had an investor put all of their money into (UK) equities during the 2008 financial crisis, their portfolio would have almost certainly taken an unbearable hit. However, by having investments spread out across different kinds of stocks, bonds and other assets, you lower your risk levels and minimise potential damage.
A Diversified Portfolio: Common Components
Equities are sometimes also called “shares” or “stocks”. Here, you buy a degree of ownership in a company or set of companies in order to gain an investment return (e.g. on their profits). For the British investor, domestic equities refer to your investments in UK companies and typically form an important part of your portfolio.
At the time of writing, large numbers of UK stocks have been sold off in light of Brexit. This might sound like a bad thing for investors, but it could actually present them with some new opportunities to make a return.
However, the uncertainty surrounding Brexit should serve as a warning to not put all of your investments into one country’s equities, where they will be subject to the health, nature and effects of that single economy.
One way to diversify the equities in your portfolio is to buy shares in companies outside the UK. For instance, you might invest in funds which buy shares in the USA, Western Europe or even across the world. Certain funds might focus on a particular region such as technology companies in East Asia.
International equities can be a great way to spread your investment risk and leverage opportunities outside of the domestic market. However, they can be subject to currency fluctuations which can impact the value of your invest – even if you make a return. So, once again, it is a good idea to spread your investments out rather than just invest in these equities.
Bonds are essentially a kind of “IOU” and are generally seen as less-risky than equities. For instance, you can buy a UK government bond and you be fairly confident that they will eventually pay the principal back with interest.
Due to their lower level of investment risk, bonds generally provide a lower investment return compared to equities. Therefore, they offer less growth potential for investors looking to expand their wealth, but are an attractive “insurance policy” against market dips and are a useful tool for investors to protect wealth as they approach retirement.
Quite often a portfolio will also include investments in property in the UK, and possibly abroad. One common approach is for investors to put some of their money into REITs (Real-Estate Investment Trusts), which allows them to buy commercial property using pooled funds with other investors.
REITs and other real estate investments can offer some strong returns, but they also carry their own risks. Looking at Brexit once again, the uncertainty here has raised a lot of questions about the future of the UK property market and house prices. So, the rule of diversification applies.
Constructing a Diversified Portfolio
When building a diversified investment portfolio, you should consider the tax efficiency of your investments, as well as some of the popular investment platforms. However, building a solid investment portfolio which meets your needs and appropriately diversifies is not easy.
At FAS, we ensure you make informed choices about how to invest your money whilst taking into account charges and taxation, as well reducing investment risk without necessarily hampering growth potential!