The Importance of Diversification
When you set up your investment, your financial adviser will go through quite a detailed set of questions with you. These will cover issues such as, how long are you investing for, what is your final objective and, perhaps most importantly, how do you feel about taking risks.
The answers to these are crucial as they help your adviser determine your asset allocation i.e. what you should invest in and how broadly to spread your money across the different asset classes.
The prices of shares move up and down significantly and, in the majority of instances, these moves are both quick and unforeseen.
Many other assets, for example, investment grade bonds, are less volatile than equities. Their behaviour is also not entirely correlated to that of equities. Hence, if you hold some money in bonds and the equity market falls, your loss should not be as great as if you held only equities.
Even if both move in the same direction, the bond segment loss is likely to be lower.
The theory behind asset allocation, therefore, is that mixing asset classes together reduces the level of volatility in your portfolio.
Planning your Strategy
Of all the questions your adviser will ask you, risk is probably the most important. If you have a lower tolerance to risk, and are worried about the effect a significant fall in equities might have, the more you will likely have invested in assets such as bonds or even cash. These can act as protection against loss when equities do fall.
On the other hand, if you have a high tolerance of risk, you will be able to weather falls in the value of your portfolio in pursuit of your goal – this will likely mean you have a higher exposure to equities.
Time is also important. If your timeline is relatively short, or if you are reviewing long term holdings in the final years before retirement, even with a higher tolerance of risk, you may start to decrease the amount you hold in equities. This helps to consolidate the value you have achieved and reduces the chances of losing those hard won savings just when you finally need them.
Visit our knowledge centre to find out about the different asset classes.
The rule to long term investment success is diversification. You should always have an amount of cash available to you in case you need it in a hurry, but no single asset class should be relied upon once your portfolio starts to build beyond those emergency requirements. Equities, bonds and property don’t offer the same guarantees, but if you understand them and are happy to accept at least some volatility, the longer term value of your portfolio might be better for spreading at least some of that money around.
NB: If an institution with which you hold deposit savings is declared insolvent, the capital will be guaranteed by the Financial Services Compensation Scheme up to a maximum of £85,000 per person, per institution. If you hold more than £85,000 on deposit, therefore, it may be sensible to spread it across more than one institution.