Everyone talks about diversification as the holy grail of investing, but what is diversification and how does spreading the risk help investors?
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The aim is to increase your gains while accepting some small losses.
The good news is every investor can benefit from diversification, no matter how much their portfolio is worth.
And diversification is one of the few aspects of investing that investors can control.
So, acting to protect your wealth is important and diversifying is the key to managing risk.
Simple But Effective Strategy
The principle behind diversification is a simple concept – keeping all your eggs in one basket is a risky game, so spread the risk across several baskets.
For investors, the baskets are countries, market sectors and companies.
After all, you don’t want all your money in widgets if a crisis comes along that destroys the widget market.
Spreading the risk is diversification in action. You choose a range of different investments across separate markets, sectors and companies, so if the worst does happen, only a proportion of your portfolio is affected.
If you diversify, the likelihood is one investment will continue to perform well.
How Diversification Works
The cost of living crisis demonstrates how failing to diversify is a costly investment decision.
Oil and gas investors have struggled for years while prices reached rock bottom. But then, Russia invades Ukraine, and the market is thrown into confusion.
Russian President Vladimir Putin is rubbing his hands with glee as oil and gas prices rocket. Russia is one of the world’s leading oil and gas suppliers and is calling the shots because European Union governments appeased the Kremlin and failed to diversify suppliers.
If the EU governments had agreed to deals with other suppliers, Putin would not be in such a strong position, and the EU would not be in thrall to Moscow.
This is how diversification works – by reducing risk.
Diversification Options
Say an investor with £100,000 to invest comes to you for advice.
You can offer three alternatives:
Don’t diversify and sink the money into the shares of a single company
Whatever the reason behind the decision, staking all the money on one company is a significant risk. Stock markets are littered with the wreckage of profitable companies falling victim to unseen consequences.
Buy shares in several UK companies
This choice is better than the first option but presents a significant risk. The shares may be across several companies in different sectors, but your money is still locked in a narrow basket of shares if the economy tanks.
Buy shares across different markets and companies
The best option for investors. Spreading beyond the UK stock market and allocating some of the money to bonds as well as stocks and shares certainly cushions against poor performance in one market or sector. Investing abroad – like the stock markets in the US, Japan or Europe also makes sense.
You Can’t Win With Every Investment
Making the right decision every time you invest is impossible.
The best you can do is diversify to smooth any losses in time. Jot down an investment policy that covers different markets, companies and investments.
Keep some money in cash, so you can react quickly to potential opportunities. After all, It makes sense to buy at the bottom of the market rather than pay full price for stocks and shares. In addition, diversifying dilutes the damage, an unexpected price drop can inflict on your portfolio.
The takeaway is diversification doesn’t eliminate investment risk but can minimise the damage to your wealth.
Four Questions To Ask About Investments
Making sound investment decisions involves more than picking a share you think could do well at random.
Each investment comes with a level of risk, and you need to understand how that risk could impact your portfolio.
Here are four important questions to think about before investing:
Can I afford to lose the money?
The rule of thumb is the higher the risk, the higher the potential return and the likelihood you could lose your stake. If you cannot afford to lose your money, don’t accept the risk and invest in a safer environment, like a bank savings account.
Safe investments like saving accounts still come with risk. For example, you will lose money if inflation and tax combined come to more than the interest rate. Your savings don’t diminish, but their buying power reduces.
Cryptocurrency is one of the highest risk investments, offering skyhigh rewards but extreme price volatility. It’s easy to make a fortune today and lose a lot tomorrow.
Can I access my money quickly
Commercial property investors have felt the pinch over getting their hands on their money.
Several multibillion property funds have frozen withdrawals in recent years as the market for shops, offices and warehouses plummeted. Fund managers did not have enough liquid cash to pay out to investors and had to wait to sell properties to repay them.
Always check who holds your money and what the terms are for cashing out of an investment.
Is the investment regulated?
Many countries have government agencies that regulate pensions and other investments.
Others also have compensation schemes that cover retail investors, like the Financial Services Compensation Scheme in the UK.
These services do not work across borders for expats, so check the local arrangements where you live or where the investment house is based.
What happens if the firm with my money goes bust?
Again, this depends on where you live and the rules the government financial regulator has in force to protect investors.
Investments are not protected by regulators if they perform badly.
Before embarking on your investment journey, make sure your finances are in order.
Pay down short-term debt, such as credit cards, overdrafts and bank loans. Build an emergency cash fund that matches between three and six months’ outgoings and max out your pension contributions.
There’s no point investing if you are paying interest on debt, don’t have the cash to cover domestic emergencies like job loss or have not taken full advantage of your pension saving tax breaks.
The Best Way To Save
The best way to save is little and often rather than a massive splurge.
This will gradually build an investment over time and lets you benefit from price changes. In months when prices have dropped, you can get more shares for your money but buy less when prices rise.
Over time, this price volatility evens out.
If you have a lump sum to invest, try drip-feeding the cash into investments so you do not find yourself in a position where your carefully planned diversification has gone to pot.
Do You Need An Investment Advisor?
Investment advisers are useful, especially when your portfolio has expanded and is difficult to manage in your spare time.
However, they come at a cost and can shave several thousands of pounds off the value of a fund.
Expect to pay up to one per cent of your portfolio’s value in fund manager fees.
If you understand your investments and the markets, you do not have to appoint an investment adviser, you can do the job yourself.
Diversification For Investors FAQ
What is diversification?
Diversification is separating your investments across different countries, markets and sectors so if one share dips, another can perform better.
Should I invest directly or through an ISA?
If your shares are sold at a profit, you are likely to pay capital gains tax on the gain you make as an individual. Investing through an ISA or pension comes without any capital gains tax on fund growth.
How do investment laws impact expats?
Expats are governed by the tax laws in the country where they have their main home, so issues like regulation, tax breaks and compensation schemes are complicated when viewed across borders.
Why should investors diversify?
Diversification has three benefits – reducing the risk of losing money; smoothing out returns and improving portfolio performance. Failing to diversify leaves an investor at a higher risk of losing money.
Does diversification have disadvantages?
Diversification has some downsides. Investors can make more mistakes because they must select more shares or opportunities and investment knowledge differs for each asset class, so more research is needed.
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