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What is diversification and how does it support investment goals?

Category: Investments & News

Diversification is something we talk about a lot when it comes to creating an investment strategy. The recent market volatility highlights why it’s important to diversify your investments and consider your risk profile when doing so.

The phrase ‘don’t put all your eggs in one basket’ is used in many contexts. And it’s important when it comes to investing too. All investments come with some level of risk, so spreading where your money is invested can mitigate the chance of sharp or long-term losses. This is known as diversification.

Your portfolio can be diversified in many ways, including:

  • Investing in a range of assets
  • Choosing stocks in different sectors
  • Spreading investments geographically

Whilst values of investments will fall in the short term at points, diversification hopefully means this doesn’t happen across your entire portfolio. Instead, other investments will experience a rise or remain stable, creating a balance. As a result, diversification can help smooth out the highs and lows of short-term investment when you look at your portfolio as a whole.

Diversification in today’s market

The coronavirus pandemic has hit markets globally. Governments around the world have taken steps to limit the spread of the virus, which has affected businesses. Other firms have found demand or operations have been affected by customer behaviour. As a result, it’s not surprising that stock markets have suffered.

So how has diversification helped you in this case?

If you’ve read the headline figures for stock market movement over the last few weeks, you’ll have seen claims of sharp falls that beat even the 2008 financial crisis. However, when you look at your own investment portfolio, it’s likely the fall you’ve experienced is different. This is due to diversification.

Depending on your risk profile, diversification means you’ll be invested in other assets too, which haven’t suffered to the same extent as stock markets. This could include cash assets, property or bonds. As a result, whilst the media may be showing significant falls in the FTSE 100, you should be focussing on the impact the pandemic has had on your portfolio with a long-term view in mind.

Diversification: Getting the right mix for you

Whilst diversification is important for every investor, there’s no single mix that’s right for everyone. It needs to consider a wide variety of factors that reflect you. When you first began investing, there should have been a range of areas that were considered, which would have informed diversification decisions. If you’re considering rebalancing your portfolio, these factors remain important.

Among them are:

1. Investment time frame

How long you’ll remain invested for is essential for choosing the right assets. This is due to longer time frames allowing you more opportunity to ride out the dips and benefit from long-term gains.

Typically, the longer you plan to invest for, the more risk you can take when it comes to investing. As a result, if you’re investing for a goal that’s 20 years’ away, your portfolio is likely to contain more stocks and shares than if you were investing for just five years. In the short term, this would mean greater volatility but over the full investment period can deliver higher returns.

As a general rule of thumb, you shouldn’t invest at all if your time frame is less than five years.

2. Investment goals

Why are you investing? Your goals will affect how much risk you’re willing to take with investments, and impact how your portfolio is diversified.

If your investments will be the foundation of retirement plans, you may be less willing to take risk than if they were to supplement a Final Salary pension when you retire. Your goals should be at the heart of every financial decision you make and it’s no different when it comes to diversification.

3. Capacity for loss

No one wants to lose money when investing. But all investments come with some level of risk. As a result, you need to consider what would happen if you didn’t receive back the full amount invested. How would it impact on your lifestyle? Would it significantly affect your short and long-term plans?

Understanding your capacity for loss and what it means for your goals can help set the right level of investment risk for you.

4. Other assets

Your investment portfolio shouldn’t be looked at in isolation. Instead, it should be considered as part of your wider financial plan. The other assets you hold, and their risk profile, will have an impact on the diversification of investments. If other assets provide you with a safety net to fall back on during market volatility or ensure long-term financial security, for example, you may be in a position to take a greater level of investment risk.

5. Your overall attitude to risk

Whilst the above factors can determine the level of risk appropriate for you, and, therefore, the right mix of assets, it’s important you feel comfortable with investment decisions too. Some people, for example, are naturally more conservative when it comes to investment risk. As part of our investment process, we’ll explain the long-term goals of investing and the impact of short-term volatility when you look at the bigger picture, providing you with confidence in the financial decisions you make.

If you have any questions at all about your investments, please get in touch. We’re here to help provide you with confidence in your long-term financial security.

Please note: The value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.

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