October 27, 2014

Diversifying an investment portfolio

We all want to make our money work as hard as we do. That is why we invest.

Any successful investment strategy will involve balancing risk and reward. If you keep your money in a bank account there is very little risk but, with low interest rates, there is also scant reward.

Equally, lumping your life savings into shares of the latest up-and-coming tech company can leave you exposed to the dangers of boom and bust – you may see your net worth rise rapidly for six months, but 12 months on from your initial investment, you could equally be left with nothing.

These two extremes best highlight the need for a stable, sensible and ultimately high returning portfolio of investments, and the process of achieving this is called diversification. Any successful investor will tell you that diversification is paramount. If constructed correctly, a diversified portfolio will reduce unnecessary risk and earn you regular returns.

Diversification takes careful planning and should always be carried out with the aid of expert advice, as it is important to realise diversification needs to be proactive, not reactive – when the average investor finally ‘reacts’ to the market, as much as 80% of the damage can already be done.

Diversification works by investing in areas that have a low correlation – if you start to lose value in one asset, your other investments will not automatically be affected by the same influencers, as they are unrelated. This amalgamation of low correlation investments lessens what’s known in the industry as unsystematic risk.

How to build a diversified investment portfolio

The fundamentals of diversification are:

Spread the wealth – Not surprisingly, the key issue of diversifying is diversifying – spreading your wealth reduces the risk of one cataclysmic market event wiping out all your investments. Often equity-exclusive investors will tell you to ensure your portfolio has a mix of different companies you know and trust in different sectors, but this is the most basic requirement. Knowing a company or being familiar with its services will help, although far more research is required. Often the most effective way is to diversify outside of shares and indexes altogether to other assets, picking up a property or two or buying bonds. The overall aim is to mitigate your risk, insulating your portfolio against adverse external changes, while still retaining the potential for high returns.

It can be summed up by an old adage – don’t put all your eggs in one basket.

Don’t rush – Depending on your existing portfolio, inject your cash at regular intervals. This is simple when purchasing equities, but can be more difficult when buying property or art for instance, so look for investments that offer staggered payments. If you can keep your cash flowing you have much more flexibility and can smooth out the peaks and troughs created by background market volatility.

Maintain a comfortable mix – Having lots of investments is not a sure-fire way of creating a diversified portfolio. Variety is key, not quantity. This works both ways as over-diversifying and spreading your money too thin will deprive you of the gains from one of your high performing investments, limiting your value. A thinly spread portfolio is also difficult to manage to the level that is required to stay ahead of the market. Theres also the possibility of not diversifying at all. Buying into too many mutual funds, for instance, could actually mean you have a duplication of holdings.

Conversely, there’s also the problem of investing too narrow. You may start out with good intentions and a well-diversified portfolio, but could be tricked into chasing the returns. People who saw strong growth on their gold investments may have ploughed more money into other precious metals and were exposed to risk when the market slowed down in 2013. Stick to your original asset mix throughout, pausing to review your exposure to risk at predetermined periods.

It is often recommended that no more than 15 investments is the optimum amount.

Don’t be afraid to sell – Don’t keep your investments on autopilot. Sure, your long-term investments such as buy-to-let property have the potential to keep churning out yields while amassing capital growth, but shorter-term investments need a closer eye and a more intense level of management. Remember the need to be proactive and keep in tune with overall market conditions. It goes without saying that you should be up to date with the forecasts of the companies you invest in.

Think global – Often there are no barriers to prevent you from investing in other countries. Shares can be bought and sold from anywhere and even the most grounded assets such as property can be purchased by foreign investors. It’s all about the investment criteria. For example, the UK’s student property market has a solid reputation for high returns and a strong outlook, so over the past year it has attracted investors from all over the world. People who have never been to places such as Bristol and Newcastle are buying property there and as a result, at the start of 2014, international buyers accounted for 52% of total investment.

The premise behind geographical diversification is that markets in different parts of the world are less correlated to one another, so if you want to invest in another country ensure your portfolio has a mix of both stable, developed countries and emergent nations. Even similar assets in different geographical locations can have a low correlation. For example, if the Asian Pacific stock markets perform poorly, there is no definitive reason the FTSE 100 will follow suit.