Diversification is a key investing concept, often explained with the phrase “Don’t put all of your eggs in one basket.”
Put simply, investment risk is significantly higher if you invest in one investment; that might be a single stock, fund or type of investment, an asset class such as equities.
The more technical explanation is that diversification reduces non-systematic risk. This is the risk that a particular company or asset class will lose value.
Non-systematic risk is overcome with diversification because, by owning various stocks or types of investments, investors are less exposed by an event which has a big impact on a single stock or asset class.
There is however a science behind effective diversification.
As an investor, you can pick different stocks or asset classes at random, hoping to diversify your portfolio and reduce your exposure to these non-systematic risks. A handful of blue-chip stocks, some corporate bonds, maybe a commercial property fund. Job done.
Chances are however this type of random diversification will leave you with just as much investment risk, and possibly a lower opportunity for rewards.
Better diversification
The approach we take is to construct ‘efficient’ portfolios; that is to say portfolios which deliver the maximum possible level of investment reward for the level of investment risk taken.
This analysis is based on a series of Capital Market Assumptions, which are long-term estimates of expected returns, volatility and correlations (how different investments typically behave together) for a range of investment asset classes.
Modern Portfolio Techniques are then used to create efficient investment portfolios which maximise expected returns for any given degree of risk.
Inefficient portfolios
If you’re investing money and not approaching diversification in this robust way, your portfolio might be less than efficient.
This means you could be taking too much risk for the potential reward you receive, which leaves you with two choices – restructure your portfolio to take less risk for the same potential reward, or keep taking the same risks but optimise your portfolio so you have the potential for higher rewards.
If you want to see how this looks in practice, email me by 5pm on Friday 19th December 2014 at martin@icfp.co.uk with the subject line diversification and I’ll reply with our risk profile questionnaire. Complete this and return it with a copy of your latest investment portfolio statement, and we will send you an initial risk assessment report.
There’s no charge for this and no obligation to buy any of our services in the future. Your initial risk assessment report will give you a description of your attitude towards investment risk, based on the answers you provide to our questions, and also a comparison of your existing portfolio against an optimised portfolio for that risk level.
We find this initial risk assessment is a great starting point for thinking about risk, diversification and portfolio optimisation.
I look forward to hearing from you.
Photo credit: Carl Richards
