Why should you spread your savings and investments and create a diversified investment portfolio?

When trying to navigate the ups and downs of the market returns, investors seem to naturally want to jump in at the lows and cash out at the highs. But no one can predict when the lows will occur. So by maintaining a well diversified portfolio and avoiding the pitfalls of market timing, you will have the foundation needed to help manage your overall exposure to market volatility.

And historically the stock market has been up more than it has been down.

So, if you could see into the future, there would be no need to diversify your portfolio. You could simply choose a date where you needed your money back and then select the investment that would provide the highest return to that date. It might be a company share or a bond or gold or any other kind of asset.

The problem is that none of us have that gift of foresight. So lets consider a few of the areas that you should be aware of:

(If you would prefer to listen to the podcast instead of reading about it, please Click Here)

1) Combining A Number Of Different Investments

Portfolio diversification helps to address uncertainty by combining a number of different investments.

In order to maximize the performance potential of a diversified portfolio, managers actively change the mix of asset types they hold to reflect the prevailing market conditions. These changes can be made at the number of levels, including the overall asset mix, the target markets within each asset class and the risk profile of underlying funds within the markets.

As a rule, an environment of positive or recovering economic growth and healthy risk appetite would be likely to prompt an increased weighting in equities and a lower exposure to bonds. Within these basket of assets, the manager might also move into more aggressive portfolios when markets are doing well, and more cautious ones when conditions are more difficult.

2) Defensive Positioning When Risk Appetite Is Low

Geographical factors such as local economic growth, interest rates and the political background will also affect the weighting between markets within equities and bonds.

In the underlying portfolios, managers will normally adopt a more defensive positioning when managing a lower risk appetite. For example, in equities they might have higher weightings in large companies operating in part of the market that are less reliant on robust economic growth.

Conversely when risk appetite is abundant, underlying portfolios will tend to raise their exposure to more economically sensitive parts of the market and to smaller companies.

3) Asset Allocation

The term asset allocation simply means deciding how to spread your money investing in different asset classes. That will include equities, bonds, property, and cash and many others as well as how much you need to hold in each of those asset classes.

Your overall asset allocation needs to reflect:

  • your future capital or income needs
  • the timescales before those capital sums are required
  • the level of income
  • the sort and amount of risk that you can tolerate

Because investing is all about risk and return.

Not only does asset allocation naturally spread risk, but it can also help you to boost your returns while maintaining or even lowering the level of risk of your portfolio. Most rational investors would be prefer to maximize their returns, but every investor has their own individual attitude to risk and we’ve covered this topic many times in the past.

I cover Asset Allocation in more detail in this separate podcast episode: https://ttwealth.co.uk/asset-allocation/

4) Investment Characteristics

Investment portfolios can incorporate a wide range of different assets, like cash, bonds, equities and property, all of which have their own characteristics.

The idea behind allocating your money among various assets is to spread risk through diversification and to understand these characteristics and their implications on how your entire portfolio will perform in different market conditions.

The idea of not putting all your eggs in one basket, is the phrase that comes to mind. Investments can go down as well as up, and these ups and downs can depend on the assets you’re investing in and how the markets are performing. It’s a natural part of investing.

If you don’t want to suffer the ups and downs of the market, then don’t invest.

ups and downs of investing

5) Changing Risk Tolerance

The potential returns available from different kinds of investments and the risk involved, change over time as a result of economic, political and regulatory developments, as well as a host of other factors.

Your risk tolerance will change over time. For example, investors in their twenties may not be too worried about a 30% fall in the market, reasoning that they have time to ride it out. Whilst investors in their forties have more responsibilities such as a mortgage and a family, may want to focus more on protecting against this kind of loss.

6) Asset Classes

When putting together a portfolio, there are a number of asset classes or types of investments that can be combined in different ways.

The starting point is cash and the aim of employing the other asset classes is to achieve a better return than could be achieved by leaving all of the investments on deposit.

Cash

The most common types of cash investments are bank and building society savings accounts, and money market funds. These are investment vehicles, which invest in securities, such as short-term bonds, to enable institutions and larger personal investors to invest cash for the short term.

Money held in the bank is arguably more secure than any other asset classes. But it is also likely to provide the poorest return over the long term. But it’s important to be able to pay unexpected expenses or to deal with an unexpected loss of income without tapping into your core portfolio, especially when markets are low.

There’s no sure way to protect your money from the effects of inflation. The only rule is that cash savings are generally the worst place to put your money long-term. The regular interest income is almost always lower than inflation, so you are always going to be constantly losing money.

Bonds

Bonds effectively are IOUs issued by governments or companies. In return for your initial investment the issuer pays a pre-agreed regular return, which is known as the coupon, for a fixed term. At the end of that term, agrees to return your initial investment.

So depending on the financial strength of the issuer, bonds can be very low or relatively high risk. And the level of interest paid varies accordingly, with higher risk issuers needing to offer more attractive coupons to attract investment. And as long as the issuer is still solvent at the time that the bond matures investors get back the initial value of the bond.

However, during the life of the bond, its price will fluctuate to take account of a number of factors:

  • Interest Rates
    As cash is an alternative low risk investment, the value of government bonds is in particular affected by changes in rates. So rising base rates will tend to lead to lower government bond prices and vice versa.

  • Inflation Expectations
    The coupons paid by the majority of bonds do not change over time. Therefore high inflation reduces the real value of future coupon payments, making bonds less attractive and driving their prices lower.

  • Credit Quality
    The ability of the issuer to pay regular coupons and redeem the bonds at maturity is a key consideration for bond investors.

    Higher risk bonds such as corporate bonds are susceptible to changes in the perceived credit worthiness of the issuer.

Equities

Equities or shares in companies are regarded as a riskier investment than bonds. But they also tend to produce superior returns over the long term. They are riskier because in the event of a company getting into financial difficulty, bond holders rank ahead of equity holders when the remaining cash is distributed. However, the superior long term future results come from the fact that unlike a bond, which matures at the same price at which it was issued, share prices can rise dramatically as a company grows.

Returns from equities are made up of changes in the share price and in some cases, dividends by the company to the investors.

Why Do Share Prices Fluctuate?

As an investor, you need to pay attention to the factors that can affect share prices and drive supply and demand. By doing so, you will be better equipped to make informed investment decisions.

It is also important to remember that share prices can go up as well as down, and past performance is no guarantee of a producing a future substantial gain.

These factors include:

  • Company Profits
    By buying shares you are effectively investing in the future profitability of a company, so the operating outlook for the business is of paramount importance.

    Higher profits are likely to lead to a higher share price and / or increased dividends.
    Sustained losses could place a dividend or even the long term viability of the business in jeopardy.

  • Economic Conditions
    Companies perform best in an environment of healthy economic growth, modest inflation and low rates of interest.

    A poor outlook for growth could suggest waning demand for the company’s products or services.

    High inflation could impact companies in the form of increased input prices. Although in some cases, companies may be able to pass this on to the consumers.

    Rising rates of interest could put a strain on companies that have borrowed heavily to grow the business. So bear that in mind with the holdings in your portfolio.

  • Investor Sentiment
    As higher risk assets, equities are susceptible to changes in investor sentiment. Deterioration in risk appetite normally sees share prices fall, while a turn to positive sentiment can see equity markets, rise sharply. And we see that time and time again.

  • News Stories
    We shouldn’t under estimate the impact the news can have on share prices. A positive news story might lead to a small increase in share price, while a negative story could result in a significant drop.

Property

The next asset class is property, which in investment terms normally means commercial real estate, for example, offices, warehouses, retail units and the like. So unlike the assets we have mentioned so far, properties are unique. Only one fund can own a particular office, building or shop.

The performance of these assets can sometimes be dominated by changes in capital values. These unusually dramatic moves in capital value illustrate another of property’s key characteristics, mamely it’s relative illiquidity compared to equities or bonds. Buying equities or bonds is normally a relatively quick and inexpensive process, but property investing involves considerable valuation and legal involvement.

The more normal state of affairs is for rental income to be the main driver of commercial property returns. Owners of property can enhance the income potential and capital value of their assets by undertaking refurbishment work or other improvements. Indeed without such work property can quickly become uncompetitive and run down. We see that in the high street, for example.

So when managed properly, the relatively stable nature of a property’s income return is key to its appeal for investors.

In Summary

Having the right asset allocation mix is absolutely vital to having a robust, diversified portfolio that will meet your investment strategy needs and objectives and is in line with your attitude to risk.

We all have different financial goals, depending on what life stages that we’re at. Our goals can be broadly categorized into essential needs, lifestyle wants and legacy aspirations.

So getting investment advice from a qualified financial advisor can be one of the most beneficial things that you can do for your personal finance and long term financial wellbeing.

Many people will be happy to do this for themselves, but for those of you that don’t, and want help to identify which investment options are right for you and your individual circumstances then please book a free inital 30 min call:

Book A Free Call

Listen To The Podcast

Remember it costs absolutely nothing to have an initial discussion with a financial advisor about diversified investment portfolios. Contact Tony Thomas on 07585 592494, email tony@ttwealth.co.uk or book a discovery call by clicking the button below.

Book A Free Discovery Call

Receive the latest TT Wealth Financial Planning Newsletter along with regular tips by email:

 Your email address will NEVER be shared or sold. You are always free to easily unsubscribe or customise your email preferences at any time. If you have any questions, please contact: tony@ttwealth.co.uk