Diversification
There are different risks for the different asset classes. Usually when we talk about risk we are referring to the risk of losing money – the capital value of your investment going down. There is also the risk you do not get the income you are expecting if, for example, a company can't afford to pay the interest on a bond, or if you have a property and there is a gap between tenants.
These risks can be reduced, but not eliminated by diversification. Diversification simply means spreading the risk of investing over a range of investments – in other words not putting all your eggs in one basket. There are two main advantages of this: minimising the impact of individual losses and spreading your investment.
- Minimising the impact of individual losses
Simply put, if you use all your money to buy shares in a single company and the company goes bust you are going to lose a lot, or all, of your money.
If you use your money to buy shares in many different companies, assuming you invest an equal amount of money into each one, and one of the companies goes bust, this will not have as much of an effect on your overall investment as if you had only invested in one or two companies.
If you have a lot of money then you can invest directly and create a wide spread. However, most investors need to use pooled investments to achieve a good spread. This is the key way to reducing the risks of individual investments (whether shares, bonds, property or cash). However, it may have little impact on the risk of wider economic problems.
As we explain in shares, the price of shares is likely to be affected by the outlook for the economic environment in which companies operate. If an economy goes into recession this may affect the share price of many companies and the value of an investment, even across a broad range of companies, may go down.
- Spreading your investment
This is the key to successful investing and is called asset allocation. Asset allocation simply means how you spread your money across the asset classes – how much you have in shares, bonds, property and cash respectively.
If you choose to invest in pooled investments it is also certainly worth considering spreading your risk across those holdings too. For example, a fund which invests only in one industrial sector, such as technology, will invariably be more risky than funds that invest across the whole range of companies in a market.
The asset classes all work differently and are largely independent of each other. If one is going up, another might be going down. It would be very unusual for all asset classes to be going down at the same time.
For example, between 2000 and 2003 many shares went down significantly. However, property values increased significantly (and bonds and cash also went up). If you had just invested in shares then the value of your investment would have reduced significantly, whereas if you had invested across the asset classes then the loss would have been much less.
You can also diversify within an asset class. Each asset class is made of different types of investment. For example, for shares you can spread your investment between the UK and overseas markets, between large and small companies, and so on.
Asset allocation
There are many factors to achieving a good return on your investments, for example:
- picking the right individual investment(s),
- judging when to invest, and
- asset allocation.
By far the most important of these is asset allocation.
The right asset allocation for you will depend on what you are trying to achieve with your money, how long you are prepared to invest, and your attitude to risk. A financial adviser, stockbroker or private client investment manager will be able to recommend a suitable asset allocation – see Related links.