Feb 13

Using Diversification to Combat Risk

One of the most important principles of investing is to ensure that you have a diversified portfolio . Diversification — spreading your money among many different investments — attempts to take a middle road through the highs and lows of market performance, allowing your money the opportunity to grow regularly with fewer fluctuations along the way.

What are some of the benefits of diversification?

The reason for diversification is simple: By including a variety of investments in your portfolio, your risk is less than if you put all your money in one type of investment.

Three key advantages include:

  1. Minimising risk of loss

If one investment performs poorly over a certain period, other investments may perform better over that same period, reducing the potential losses of your investment portfolio from concentrating all your capital under one type of investment.

  1. Preserving capital

Not all investors are in the accumulation phase of life; some who are close to retirement have goals oriented towards preservation of capital, and diversification can help protect your savings.

  1. Generating returns

Sometimes investments don’t always perform as expected, by diversifying you’re not merely relying upon one source of income.

Choosing a mix of investments

What goes up usually comes down.

All securities behave differently from one another, going up and down in separate cycles and to varying degrees. An individual stock is affected by a combination of different elements, including the overall stock market, health of the industry the company does business in, and the company’s own performance. Though stocks generally vary more than fixed-income investments (such as bonds), fixed income prices can be affected by changes in interest rates and the overall fixed-income market.

Diversification within and across asset classes

Diversification can be achieved in many ways, for example:

  • Across different asset classes including growth and defensive assets. Growth assets generally provide longer term capital gains, but typically have a higher level of risk e.g. shares or property. Defensive assets generally provide a lower return over the long term, but also generally a lower level of volatility and risk e.g. cash or fixed interest.
  • Within asset classes such as purchasing shares across different industry sectors.
  • Across different fund managers if investing in managed funds.

The risk or variability of different markets are impacted by: domestic/international developments and economic factors – such as production, employment, monetary policy, and levels of investment. How you diversify across asset classes, therefore, has a direct effect on the amount of risk, or variability of returns, you are likely to have.

For example, during periods of increased share market volatility, your share portfolio may suffer losses. If you also hold investments in other asset classes such as fixed interest or direct property that may perform better over the same period, the returns from these investments can help smooth the returns of your overall investment portfolio.

Practicing diversification in your savings plan

Mutual funds that invest in both stocks and fixed-income investments (balanced funds) offer one way of diversifying both across and within asset classes.

Another way of diversifying is to choose your own mix of investments, rather than invest in a fund where the mix is determined by someone else. However, if you take this route, you need to be more diligent about evaluating your choices and may want to get assistance from a professional adviser.

Two simple rules

When diversifying your investments, remember to:

  1. Reduce “security-specific risk.”

Purchase a broad range of investments across various companies and industries rather than a limited selection of individual securities. This way, no single investment will dominate the performance of your retirement account.

  1. Spread your money across different asset classes: stocks and fixed-income.

Each asset class has its own unique risk and return attributes. And because the risks of one asset may complement the risks of another, it may be possible to achieve higher investment earnings and reduce your portfolio’s volatility.

By diversifying your investments, you can achieve smoother, more consistent investment returns over the longer term, balancing out the ups and downs, protecting your savings from short-term losses and allowing them the opportunity to grow over time.

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Article Source: Russell Investments




Source: Russell Investments

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