According to a series of global financial skills surveys, most people struggle with a range of financial concepts, including compounding, the impact of inflation and also, the concept of diversification.
When it comes to investing, diversification is a risk reduction strategy that is a fundamental pillar of long term investing success, without it, investments become akin to a car operating without brakes where unplanned and unexpected events can take an significant toll for the worse; personal wealth that took years to build can be wiped out in weeks, days or even hours.
A very basic yet highly effective risk reduction strategy is diversification. At its simplest, diversification is the spreading of risk. With investments, it is the allocation of investment wealth into a variety of different investments, including equities, commodities, property, bonds and even cash.
The rationale behind this tried and tested risk reduction strategy is the likelihood that investments will face myriad challenged over the long-term. Companies will come and go and so will the value of their shares (also called equity). The value of Bonds will rise and fall; you only have to think back to the start of the 2008 Credit Crunch and resulting Great Recession to understand its impact. Property values rise and fall, but even a slight slow-down in the property market, or a change in rental legislation can have an outsized, negative impact on investment wealth. So it’s little wonder that diversification, when correctly implemented can protect wealth over the long-term.
For those who invest in company shares, the best and most effective strategy is to spread the risk across different companies, operating within different sectors and across different companies. But a better option is to increase the types of assets invested in. For this to be effective, it is important to understand the link between rates of return and risk. Normally, the higher the expected rate of return, the higher the risk also. A well-diversified portfolio consists of different types of investments carrying varying degrees of risk. Most investment advisers agree that diversification will not provide 100% risk-free investing, it can significantly reduce it, helping you reach your long-term financial goals.
Aligned to your goals
One big feature of diversification you need to factor are your financial goals timelines. If for example you have been investing to deliver an income in retirement, then you choose a strategy that minimizes the risk of loss the closer you get to your target retirement dates. For example, moving investments out of high risk commodities and increasing your investments in cash or money markets is a way of doing this.
Diversification is an evolving process, not a one-time event. So, at a minimum, you really need to be examining how well your investment strategy is performing and your timeline to your investment goals. In other words, can your investments deliver your financial goals…will they deliver an income in retirement that will meet your needs. If so, well done! If not, reconsider your investment or your timelines. Above all, be aware of where you are now, where you want to get to and whether or not your current investment strategy can actually deliver.
Investing is not a once-off action; it is a complex process that requires discipline, skill and lots of patience. For investing to be a long-term success, sound diversification need to be taken to protect wealth. If done consistently, it can help deliver successfully on long-term investment goals.