What is Risk Diversification?
We have all heard of the term ‘putting all of your eggs in one basket’ and we are warned of the dangers of doing so. When it comes to investing money, this rule is no different. In a nutshell, risk diversification is ensuring all of your financial assets are not in the same basket.
To give a simple example, an investor has USD100,000 and decides to buy gold. Over night the price of gold suddenly halves. The following day the investor now has only USD50,000. This example is extreme, but it clearly highlights the need to diversify to reduce exposure in any one asset.
A better idea would be to buy a lower amount of gold, and also buy into other asset classes in order to diversify and offset risk.
In order to diversify the level of risk within a portfolio, it is common to invest into various asset classes with varying degrees of risk. A top tip to remember when considering risk is the more you take, the higher the potential for returns.
An asset class is simply a group of investments that have similar characteristics within the market place. The main asset classes include cash, equities (stocks & shares), and fixed interest (bonds). Other examples are commodities (gold, oil, etc…), property, and alternatives.
Cash is perceived as the lowest risk asset class. Cash sits within a bank account and is not affected by fluctuations in world markets. The only real issue with cash is the impact of inflation over time. For the lack of risk taken with cash, the returns are usually very low.
Next comes fixed interest or bonds. These could be government bonds or corporate bonds. A bond is basically a loan that the investor gives to the provider, in return for a set interest rate or coupon and promise of the return of capital in future. The risk of the provider defaulting on the repayment of the loan means that the returns are generally higher than cash.
Equities are considered as highest risk. The value of stocks and shares fluctuate daily, making equities a more volatile form of investment. It is very difficult to predict how stock markets will perform over the short term.
How much Risk to Take?
No two investors are the same, and so deciding on how much risk to take is a very personal question. There are many variables that can decide this, including investment horizon, attitude to risk, age, and perceived thoughts on current markets.
Before undertaking any form of investment, a comprehensive risk profile of the investor should be undertaken. This will include various questions regarding how comfortable the individual would feel as a result of different market movements, the level of return the investor requires, and if they have previous investment experience. After answering these questions, the investors risk score will be calculated. This can be classified as low, medium, and higher risk investors, or numbered 1 to 5 (1 being a low risk investor and 5 being a higher risk investor).
The Personal Financial Journey
Risk diversification always needs to be considered no matter whether an investor is saving for retirement, their children’s university fund, or simply saving for a rainy day.
An important consideration is how many years remain before requiring access to the investment.
A young professional considering saving for retirement in 35 years can afford to have a higher risk exposure, therefore a higher proportion to equities could be advised due to the length of time until capital access is required.
An older investor nearing retirement age would require a higher exposure to fixed interest and lower exposure to equities in order to limit volatility and fluctuations in value before access to the capital is required in the short term.
An industry standard when investing is to have a five-year minimum investment horizon. Anything shorter than this would usually result in a recommendation of cash savings only.
How to Diversify
It does not matter if you have USD10,000 or USD1 million to invest, risk diversification is always important. The main reason of investing money is to gain a return over time, and so each individual’s nest egg needs to be diversified adequately for the optimum risk/return.
There is no magic formula to create the perfect investment portfolio, however a top tip to follow is to always spread your risk over different asset classes. None of us have a crystal ball, so bullet proofing your investment portfolio is essential.
If an investor has a large property portfolio, then diversifying into more liquid asset classes could be a good idea. If an investor holds large quantities of stock, lower risk fixed interest options could be added to compliment the portfolio.
Mutual funds can be described as a selection of various investments in various asset classes bundled together as one and managed by a fund manager on the investor’s behalf. There are thousands of mutual funds worldwide offered by fund houses such as Blackrock, Fidelity, and Aberdeen Asset Management.
Mutual funds are a good way of diversifying risk due to the huge choice of funds available to investors.
By investing in mutual funds risk diversification can be automatically achieved within the fund on the investors behalf. If an investor wants to buy a US company stock such as Apple, he could instead buy a US equity mutual fund which not only invests in Apple, but also Boeing, Visa, Microsoft, and so on. If Apple’s share price were to fall, the investor would be protected by the other companies within the fund and therefore limit the losses realized by Apple.
If the investor wanted to diversify further, then he could also buy a European equity mutual fund. This further dilutes the investment risk as his exposure to the US market is lowered.
This process can be repeated over and over again until the desired level of diversification has been achieved.
It is important for any investor to have an idea of the level of risk that they are comfortable in taking before buying into any asset class. In addition an adequate time horizon of at least 5 years should be considered along with a mixture of various asset classes within the portfolio.
It is always advised to seek relevant financial advice before choosing an investment strategy. It should also be noted that the value of even the most diversified investment portfolios could go down as well as up.
If you would like to talk about any of the topics covered in this article, please contact me on the channels below.
LinkedIn: Chris Keeling DipFA CeSRE
N.B. Please ask my permission before copying my content, thanks.