How Diversification Protects Your Investments
Gambling
Everybody knows the expression that "gambling is a mug's game!"
Placing a bet on a horse, pouring cash into slot machines or even buying a lottery ticket, generates a bit of a thrill, and for the lucky few might even result in a win, but most people know that they are likely to have lost their money.
When it comes to investing for your future, gambling and hoping for a win is not a good strategy for success.
This is what one might call very high-risk investing!
Some people liken the stock market to gambling.
The rationale, is that even if you buy shares in a company that has been successful in the past, there is no guarantee that it will do the same in the future, so essentially, you are gambling on the future performance of the company.
There is some truth to this notion, and that is where financial advice can help, as financial advisers are trained, and regulated, to ensure that they understand how to mitigate risk on behalf of their clients.
There are some basic principles of risk-management when investing, one of which is diversification.
Managing Risk
Many things can affect the value of investments and equities, both short-term and long-term.
Some are partially or wholly within a company's control, such as; sales performance, administrative efficiency, its skills and staff retention, its ability to manufacture and deliver products and services or manage a portfolio.
Other factors can influence the value of an investment which are entirely out of its direct control, such as; stock market confidence, interest rate changes, wars, political and legal outlook, changes to regulations, scientific developments, etc.
There is no such thing as a "sure thing"...in a horse race, or in an investment.
There are, however, a number of indicators which are generally predictors of good companies to invest in.
Those that meet the criteria are "sound" choices, but there is also the science of applying "diversification" strategies to assist in de-risking investments.
Additionally, a good financial adviser will understand enough about the political and economical landscape to be able to adjust their advice to suit the potential impacts of major events.
They should also be able to demonstrate that they have sound judgment when it comes to diversifying investments.
What Is Diversification?
Diversification is essentially, taking an approach of spreading investments across a number of different asset classes, industry sectors, currencies and geographies, to ensure that they are weighted in a way that provides protection.
For example; If one asset in a portfolio is affected negatively by a potential political event, it might be offset by another asset being affected positively by the same political event. The positive impact on one asset would counteract the negative impact on the other asset, resulting in stable performance across the two assets.
In another example, if one currency performs poorly against another, but assets are held in both currencies, the decline in value in one currency may be offset by the increase in value in the other currency.
Although it can become complicated diversifying across asset classes, currencies, geographies and industries, it is a key element of the role of a financial adviser when creating a portfolio to match your chosen risk-profile.
Although diversification is a very effective way of protecting a portfolio long-term, it comes with a caution.
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Too Much of a Good Thing
Whilst diversification is important, like many things it can be taken too far.
If a portfolio of investments is over-diversified, it can dilute performance and stifle growth.
Diversification can also increase costs by having investments spread across too many assets.
There is a sweet-spot for general diversification, and there is a specific sweet-spot for each client, based on their goals and their appetite for investment risk.
"As Joel Greenblatt pointed out, holding eight stocks eliminates 81% of the risk of owning just one stock. Owning thirty-two stocks eliminates 96% of the risk." David Einhorn
There is also a point, past which further diversification delivers relatively little additional risk-protection, and where the optimum reduction in risk with the smallest number of different investments occurs.
Diversification For You
As an independent financial adviser, Fane Financial Services can guide you on the best ways to diversify a portfolio, in order to mitigate risk, but maintain investment performance, and they are one of the advisers we recommend.
They can provide a full review of your financial situation and create a strategy that helps you to make smart decisions with all aspects of your finances and avoid making expensive mistakes.
Lifestyle Advisor, Poole
Fit to Retire Ltd is a lifestyle advisory business based in Poole, Dorset.
We provide estate planning services and health and wellness advice, and we introduce our clients to experienced and respected financial advisers for specific financial advice on savings, investments, inheritance tax planning and protection (including insurance products).
Contact us by telephone on 01202 070071.
Contact us by email at clientcare@fittoretire.co.uk
Fit to Retire Ltd is located at: FOUNDRY, The Dolphin Centre, Poole BH15 1SZ
Whilst this article provides some information related to personal finances, it should not be construed as personal financial advice. For personal investment advice please contact Fane Financial Services.
It is important to remember that investments can go up as well as down in value, and any investment you make should be assessed for its risk profile and its appropriateness for your circumstances.
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