Throughout history, investors have lost fortunes because they concentrated their wealth in too few investments. We’ve all heard the saying that you shouldn’t put all your eggs in one basket – yet many people still put their faith in just one or two stocks, in a single investment fund they bought on a tip-off from a friend, or in more exotic (and probably more risky) products they’ve found advertised on the internet. As a result, they’re totally exposed when things go wrong.
What’s particularly tragic about these cases is that the alternative – spreading your money around via a process known as ‘diversification’ – is really easy, provided you understand a few key concepts.
Invest in the shares of only one company and your wealth is tied to the fortunes of that company, for better or worse. Invest in 100 companies, on the other hand, and you reduce the risk that your overall wealth will suffer. Why? Because the chance of all 100 companies performing badly at once is significantly lower – based on historical data, at least.
That last point is an important one. Investing always carries the possibility that you might get back less than you started with, and past performance is no guarantee of future performance. If you’ve invested before you’ll recognise that warning from every piece of literature you’ve been given! There have been times in the past when the majority of companies listed on the UK stock market have seen prices fall simultaneously. This happened, for example, during the global financial crisis of 2008.
So, in addition to spreading your money around, it’s also important you choose the right mix of investments. Otherwise, you may not reduce your risk by as much as you think.
How to diversify your investments
There is no single ‘right’ way to diversify your portfolio. The way that’s right for you will depend what you’re trying to achieve with your investments, and on your investing personality. However, the general principles of diversification are the same for everybody:
- Spread your money across a number of things so that you don’t concentrate all your risk in one, or a handful of, investments.
- Invest in a mixture of things that each carry different levels of risk, in order to control the overall level of risk in your portfolio.
- Investing in 100 shares may be less risky than investing in one, but you can do even more. You can further reduce the risk to your portfolio by including investments from multiple sectors and geographical regions, and by adding other types of investment, or ‘asset classes’, to the mix.
As the graph below illustrates, different assets carry different levels of risk, and by taking higher risks you give yourself the potential to generate higher returns. It follows that if you transfer some of your wealth from higher-risk assets to lower-risk ones then you will reduce the overall risk to your portfolio, but also reduce potential returns.
Different asset classes also behave in different ways. Government bonds, for example, tend to rise in price while shares are falling – though there can be no guarantee of this. This trend has occurred historically because government bonds are ‘fixed-interest securities’ and therefore offer more consistent returns than shares. Many investors regard them as a ‘safe haven’ at times when the stock market is volatile.
You can read more about the major asset classes listed here by reading our article entitled ‘What can you invest in? A quick guide to shares, bonds and other assets’.
How investment funds and financial advisers can help
Keeping track of lots of individual assets can be a daunting task. A much simpler solution is to buy investment funds that contain those assets and leave the diversification worries to professional management. By purchasing a fund that invests in, say, large blue-chip companies, another that invests in smaller companies and others that invest overseas, you can easily spread investments across hundreds of different assets.
If you have a financial adviser then they can help you to build and maintain a diversified investment portfolio. This may include individual shares, funds and other types of investment, and will be tailored to your individual needs and goals.