Diversifying your portfolio by buying a mix of investments can help to protect it from the ups and downs of the market.
Different types of investments perform differently under different economic conditions. When you diversify, you aim to make these differences in performance work for you. The goal? A more balanced return.
The two company island
You might have heard people explaining diversification using the phrase ‘don’t put all your eggs in one basket’. But that’s only part of the story – here’s an illustration.
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Two company island
There was once an island. And on that island were two companies.
One company sold Wellington boots. The other company sold deckchairs.
People who invested in the Wellington Boots company saw strong results when it rained. But poor results when the weather was sunny.
Investors in the deckchair company saw the opposite. Sunny weather brought good sales. And when it poured, they were poor.
But if you invested in both companies, while you might not increase gains, you could balance out the uncertain fluctuations and smooth volatility.
To take full advantage of the island’s investment opportunities, the year-round weather picture needs to be considered.
Only by investing in both companies could investors diversify between Wellington boots and deckchairs, for the greatest effect. That way they would be doing well come rain or shine.
Remember though, just as fashions can change...
...diversification is not a guarantee of good returns and you could still lose money.
Why market conditions matter
Diversifying your portfolio requires investing in more than just one company. It can mean introducing investments from different countries, different sectors of the same market and different asset classes so they behave differently in response to market conditions over the medium to long term. These investments all carry different types of risk of loss and different potentials for gain.
In a well-diversified portfolio, only a small chunk of your money is tied up in one area. So a single bankruptcy or industry slump isn’t going to wipe out your total return. But if you hold shares of just one company or in a single industry and it collapses, you could lose all your money. The same goes if you invest in one sector that performs poorly – like the banking sector in 2008. By not diversifying, you could find yourself with heavy losses.
Of course, even well-diversified portfolios are at risk from market movements. All investments can fall as well as rise, so you could lose money. However, a portfolio that’s diversified can generally be expected to move significantly less – to both gain and lose less than non-diversified portfolios – and therefore produces more balanced returns.
How to diversify
You can diversify your portfolio in a few different ways:
- across different types of investments
- across countries and markets
- across different industries and companies
A diversified portfolio is likely to include a wide mix of investment types, markets and industries. How much you invest in each is called your ‘asset allocation’.
The main types of investments are cash, bonds, property and shares. If you invest in each of the investment types, you’re likely to get more consistent returns, i.e. your portfolio is more likely to both gain and lose less. That’s because different things influence the value of each asset class.
Gilts and bonds vs. shares
Two different types of investments that are held together in a portfolio to provide diversification are gilts and bonds and shares. This is because traditionally they have been what is called ‘negatively correlated’. This means that, historically, when one has been going down in value, the other has tended to be going up, though this is not by any means always the case, and what may have happened in the past is no indicator of what might occur in the future. They are unlikely to cancel each other out completely, but this characteristic helps to provide balance to an investment portfolio. To explain why market conditions matter, let’s look at how a fall in interest rates affects these two asset classes:
- Gilts and bonds
The value of issued gilts and bonds is heavily influenced by movements (or expected movements) in interest rates. If interest rates in general fall, the value of a bond tends to rise since the fixed rate of interest it is paying becomes more attractive. If the reverse happens and interest rates rise, the income that an issued fixed-rate bond offers becomes less attractive and so the value of the bond falls.
The other key factor influencing the value of bond is the credit risk they offer. A bond is essentially a loan to a company, and a gilt is a loan to the UK Government. If there is concern about whether the company can pay its debts, this will have a significant impact on the value of bonds issued by that company.
The value of shares is influenced by two key things: the performance of the company itself and the more general economic conditions – both overall and in the sector in which it operates. Economic performance of the wider market will influence the company’s future performance. If the economy is performing well, there is an expectation that companies will make increased profits. At this time, there tends to be demand for company shares, and so their value rises. If the economic outlook is bleak, investors tend to move away from shares and so their values fall. This said, there is no guarantee that they will move in this way. Sometimes both move in the same direction and that can persist for long periods.
If your portfolio contains both of these asset classes, and if these assets behave in the manner outlined above, the value of the gilts and bonds would rise at the same time as the value of your shares fell. We’d say these asset classes are ‘negatively correlated’. Your attitude to risk and timescales would determine how much of each asset class you held.
Diversifying with collective investments
One of the simplest ways to diversify is through funds or collective investments. These include unit trusts, Open Ended Investment Company (OEICs) and Exchange Traded Funds (ETFs). These all invest in a variety of shares, gilts and bonds or other investment types, depending on the fund’s objectives. We’ll look at these types of investments in more detail later.
As well as diversifying using different investment types, it’s a good idea to hold a balance of cash savings in your portfolio. An investment portfolio that’s diversified can generally be expected to move significantly less and therefore produces more balanced returns. But remember, even well-diversified portfolios are at risk from market movements. All investments can fall as well as rise, and you could lose money.