Diversification: what is it, why its important and how to manage it now

In the many video call discussions, webinars and in the articles we have written recently we have discussed investment diversification. In this article we explain what it is, why it is important and how to manage it in these volatile markets.

What is diversification?

Diversification is spreading your investment across different asset classes and different types of investments to reduce the risk. If all your money is in the same type of investment, for example airline stocks, and there was a drop in that sector, then all your invested money would be at risk of falling in value. It’s what is often referred to as not putting all your eggs in one basket.

There are a number of ways you can diversify, and it works because different types of investments respond differently – both positively and negatively – to economic news, and other impacts on the world of finance and investments. Using financial speak for a minute, if two assets, or types of investments, are positively correlated they will respond in the same, or a similar manner and direction; if they are negatively correlated, they will respond in opposite ways, for example when one goes up, another might go down; and if there is no correlation, it means the way one moves is completely separate to how another might move.

You can diversify by types of investment or asset class: This means shares (also called stocks), fixed interest (also called bonds), money market or cash, property, alternatives, commodities etc.

You can also diversify geographically: you may have some investments in Europe where you live but also some in your home country (perhaps in the local pension system). Your actively managed investments in each market can also be diversified geographically by investing in different markets.

You can diversify by currency if that is relevant for your needs and you can diversify by sectors, for example, health care, travel, education, technology, banks, resources and even by types of stocks, for example those that pay higher dividends and those that don’t.

Why Diversification is important

It is important because it can help you achieve your goals with a lower level of investment risk. It will buffer the shocks and reduce the amount of movement (volatility) in your investment. This doesn’t mean it will completely insulate it guaranteeing positive returns, but it will reduce the amount of volatility in your investments.

As an example, in the five weeks to 20 March 2020, in the grip of the Covid-19 pandemic, stock markets, measured by the US S&P500 index fell by 29%. In that same time, the fixed interest index reduced by only 3% and cash remained steady.

How do you manage diversification now?

How you diversify should always be driven by your objectives, what you want to achieve from your investments, and your risk profile- the amount of volatility you are comfortable adopting to get to your goals.

For example, a balanced investor might have a portfolio with 50% invested in Stocks and other growth assets, 35% in fixed interest, 5% in alternatives or property, and 10% in cash.

However, you need to ensure your portfolio mix is right for you and rebalance from time to time. In periods when the economy is strong and markets perform well, growth assets such as shares will grow faster and that can push a balanced portfolio into an imbalanced position resembling a growth portfolio. Similarly, in down markets that we are currently experiencing, falls in the stock market can reduce that component’s value relative to other components and make the portfolio more in line with a conservative portfolio than the balanced one you set out with. This is the same whatever your starting position: conservative, balanced, growth, speculative.

The key issue here is that if your portfolio has adjusted due to market movements into a more conservative structure, you may not be able to take full advantage of the market recovery when it occurs. Rebalancing is vital to keep your investments aligned to your goals and to make sure you can stay on track to achieving your targets.

For existing investors, this is the key action to be taking right now, alongside asking yourself the question of whether your investment portfolio remains aligned to your longer-term goals. If the answer is no you need to re-evaluate both your investments and your goals.

The other aspect that is important right now for new investors is to align long-term strategic asset allocation with short term tactical positioning. That means, the long term is clear, but that diversified allocation of assets may need to be adjusted if you are entering into the market now. There are likely to be some very good medium to long term opportunities for investors however managing this is vital in relation to how your investment is set up and the short-term market volatility.

If you want to check if your investments are still in alignment with your goals, or speak about investing in this market in general, contact us and we will assist you in reviewing and recommending the appropriate course of action. Proper management of your investments in difficult and negative markets can result in benefits when markets recover and move back to growth.