A two-minute guide to diversification and the benefits of it
Most people are put off investing money in financial markets for fear of losing money. Who can blame them? The press is full of horror stories of people losing their life savings because of market crashes or failing companies.
Bad news sells better than good news (we all have a slightly macabre interest in the misfortune of others).
People can lose money from investing. Of course, if you don’t want to take a risk there’s always the trusty savings account. They provide a return, albeit a meagre one because interest rates are low, and your money will be safe. The Financial Services Compensation Scheme (FSCS) protects up to £85,000 of money in banks, building societies and credit unions.
However, in the current climate inflation will eat away at the value of your savings. Investing, which does come with risk, offers the potential of higher returns.
The benefits of diversification
Experienced investors (you know the type - bald, pasty complexion with thick-rimmed glasses) take steps to mitigate risks.
They call it diversification, which basically means spreading your money around.
For instance, while stocks returned an average of 7.7% between 2004 and 2017 it hides the fact they fell nearly 40% at the height of the financial crisis in 2008. Just imagine if you had invested all your money in stocks in 2007. You would have lost more than half your money by the end of the following year (I feel queasy just writing that).
However, if you had invested some of your money in government bonds, some of those losses could have been offset, because bonds rose 10% in the same year.
Diversification doesn’t guarantee you won’t lose money but it should smooth the highs and lows and help you avoid that emotional rollercoaster ride.
It also helps you retain access to the money you need: In times of stress the ease in which you can buy and sell an asset is critical. This varies between assets, and is known as liquidity. For instance, property can be more illiquid than equities. Diversification can help.
Too much diversification?
Don’t go mad though. Investing in too many different assets can leave you swimming in confusion.
There is no fixed rule as to how many assets a diversified portfolio should hold: too few can add risk, but so can holding too many. Hundreds of holdings across many different assets can be hard to manage, and diversification for the sake of it runs the risk of poorer performance, sometimes called “diworsification”.
If you are unsure as to the suitability of your investment, speak to a financial adviser, and remember the value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.
Read more: Is investing for me?