Diversification: Why you should spread your savings and investments
Diversifying your investment portfolio is one of the best ways to reduce risk, thus promote growth. In this guide, we're going to take a look at what diversification is and how it reduces risk. We'll also walk you through how to create a good investment portfolio.
What is diversification?
Diversification is the act of spreading your wealth over different types of investments so that it's not concentrated in just one place. A well-diversified portfolio will have funds invested across a variety of different asset classes, such as cash, equity, bonds, commodities, and property.
How does diversification reduce risk?
Diversification reduces risk by making sure your money is spread over a variety of investments, so, if one of them suffers a negative effect, only a small portion of your wealth loses value. If you were to keep all your funds invested in just one area, you would be increasing the risk of a single factor impacting the entirety of your money. By adopting a diverse strategy, you can ensure your portfolio is much less likely to underperform or lose value.
However, diversification is not just a case of splitting your money between different stocks or placing half your funds into a different savings account. The aim is to spread your wealth over different asset classes so that you have a strong, balanced investment portfolio. As each asset class is impacted by market factors in different ways, a diverse set of investments is much more likely to remain stable.
For instance, property investments traditionally do well when interest rates are rising, while fixed-rate investments, such as bonds, are susceptible to high interest rate environments as they are static - causing them to fall behind the market rate. If your portfolio leant too heavily on bonds, you would see a bigger loss of value than if your money was split between bonds and some property interests, which could help to balance out the negative impact.
How should I diversify my investment portfolio?
If you're looking to build a well-diversified portfolio or you're aiming to expand upon a few investments that you've already made, it's important to focus on diversifying your interests so that you can create the right balance and reduce the level of risk. Below, we'll take you through how to create a good investment portfolio in four essential steps.
1.Consider your investment goals and choose asset classes accordingly
The first step to creating a diverse portfolio is to identify what your investment goals are. Consider key points like whether you're looking for slow and steady or quick growth, how long you're willing to invest for, and which types of investment you would be comfortable with, as this will build a clearer picture of what type of asset classes you should be looking at for your portfolio. You should also consider other details, such as your age, dependents, and other financial commitments before making a final decision.
While the main aim of diversifying is to protect your wealth, it's also important to get a balance between low and high-risk asset classes. For example, if you were willing to invest for the long term and you identified your main objective as protecting your wealth while experiencing a sensible rate of growth, you would probably need to look at low-risk assets like ISAs, lower-risk peer-to-peer lending platforms, and bonds to form the core of your investments. You could add some equity or property investments to further diversify your portfolio and guard against both inflation and interest rate rises.
On the other hand, if you're out to make money as soon as possible, you may wish to diversify your portfolio with riskier asset classes. This might mean that you lean more heavily into the likes of shares, property, commodities and high-risk P2P platforms over investments that offer a lower rate of return. This option is often more popular with younger investors who have much less on the line should some of their assets fail.
If you're unfamiliar with the main types of investment on the market, be sure to read our guide to asset classes to find out the strengths and weaknesses of each one. Should you still feel unsure about choosing the right combination of assets, it's often worth seeking advice from a financial advisor who will be able to provide professional guidance.
2.Review any existing assets in your portfolio
Should you already have a number of investments — especially in stocks — a good way of checking whether your portfolio is diverse enough is to review its performance and see whether it matches the way the markets have performed over the past few years. If there is a strong correlation, it implies that your portfolio is not fully diversified, as having a variety of investments across asset classes and investments should ensure your performance deviates from the market pattern. With a well-diversified portfolio, your investment should not follow the wider market too closely as you'll have a mix of assets that are chosen to respond differently to both positive and negative market factors.
3.Diversify your investments within each asset class
While choosing to make a series of investments over a variety of asset classes is a good start, to really diversify your portfolio you will need to take it a step further and make sure your investments are spread out within each asset class. This extra level of diversification will further protect your wealth from market factors that may have a negative impact.
Diversify your sectors
Firstly, consider investing in a selection of different sectors to make sure that your money is not hit by a downturn in one industry. If you choose an unaffiliated field, the downturn will likely not have any impact. Even if you have previously had success putting your money into a certain area, try to make any subsequent investments in other places.
Diversify your locations
Spread your investments out globally, rather than in just one market. This will help to shield your money from any economic issues in a country, as one market's poor performance doesn't mean that another will fail as a result. However, it's worth remembering that some countries may have more unstable economies than others, so be sure to exercise caution.
Diversify your companies
Lastly, it's worth thinking about diversifying your investments out across a range of different companies or organisations to eliminate the risk of one underperforming and negatively affecting your money. A healthy spread of investments in both large and small companies across different sectors and global markets is the best way to build a diverse portfolio.
4.Review your investment portfolio on an ongoing basis
Once you've built up a fully-diversified portfolio you're happy with, it's key that you recognise the hard work isn't over. You will need to carry out an investment portfolio review on a regular basis to make sure that it's performing in the right way. Try to stay up to date with the various markets that you have interests in and make any adjustments to maximise your returns when required.
Adjust your investments to suit your goals
You may also find that your goals shift with age: typically, investors grow to be more conservative as they get older and their wealth increases. This means that you may wish to shift the angle of your investments, swapping out riskier asset classes for more secure, long-term types. Should you make any changes, be sure to maintain the diversity of your portfolio to ensure it's still well protected.
Beware of over-diversification
If you make more investments and expand your portfolio, you need to take care that it does not become over-diversified — a scenario where you have too many assets across different classes. With so many interests to pay attention to, it can become more difficult to manage your portfolio. Should this occur, it's often easy to get bogged down in the minutiae of one or two investments when you should be paying more attention to the bigger picture.
Your portfolio's growth can also be hampered by too much diversity, as too many small investments might not perform as well as a larger, well researched investment. Furthermore, many investments come with a fee to buy or sell the position, hence by over-diversifying you increase the fees relative to the potential gains, thus eating into your potential profits if you make an excessive number of investments.
To prevent your portfolio from becoming over-diversified, you need to make sure you maintain a healthy balance of diversification when you add additional investments. There are a few warning signs to watch out for that indicate you're in danger of overcomplicating things:
- Making an excessive number of individual investments: If you find that you're making too many individual investments, it might be time to scale back to a manageable amount. For a solo investor, between 20 and 30 investments is considered to be a healthy amount.
- Putting your money into an investment that's similar to another: Making a separate investment that is similar to another cannot be considered as a diversification strategy as you're committing funds to something that shares the same risk profile. For example, investing in two similar healthcare companies will mean your money is exposed to the same market factors and will simply increase the size of your portfolio.
- You're struggling to keep track of all your investments: Should you make too many individual investments, you may find it more time-consuming to manage their performance. While this can be harmful for your portfolio in general, it's also a sign that you have spread your investments too thinly.
- Your portfolio is not providing expected returns: We've mentioned how over-diversification can impact the performance of your portfolio, so if you're not making satisfactory returns even though your assets have been performing well, it could be an indicator you've got too many smaller interests.
Diversifying your portfolio with peer-to-peer lending
When you're looking to create a balanced portfolio, you may find yourself exploring ways to spread your wealth outside of the standard asset classes. One option to consider is peer-to-peer (P2P) lending — which can offer a sensible risk-reward alternative for those looking to grow their money.
P2P lending platforms connect those looking to lend money with those in need of a loan, with interest being paid directly to the investor/lender. As the substantial cost base of the banking model is removed, investors can enjoy higher rates of return than in many other investments — a great way to beat the high levels of inflation that are currently eroding many investors’ and savers' assets.
Read our guide: What is peer-to-peer lending?
You can even enjoy P2P lending within a tax wrapper by opening an Innovative Finance ISA.
Read our guide: What is an Innovative Finance ISA?
Here at Lending Works, we provide an established peer-to-peer lending platform for you to securely invest your money. Our investors benefit from high rates of interest: up to 5.4% p.a. with our Growth product and up to 3.8% p.a. with our Flexible product, which is ideal for protecting your money from inflation and growing your wealth.
As with all investments, your capital is at risk. We take care to manage risk as much as possible with our innovative Lending Works Shield. Through a contingency fund, we can help mitigate the impact of borrowers defaulting on the loans they've taken out. This means that the risk attributed to an investment with us is more modest, giving you a good alternative to other low-risk assets.
Read our guide: How safe is peer-to-peer lending?
What's more, we also use diversification as a safety measure with your investment. We take the money you've put into your account and divide it between multiple borrowers, rather than just the one. This way, you're more protected should someone default on their loan, as only a fraction of your money will have been invested in the loan.
If you'd like to find out more about how we can help you diversify your investment portfolio, be sure to get in touch.
It is important that we highlight that with any peer-to-peer lending platform, your capital is at risk.