In order to spread the risk of your investments it is best to diversify your portfolio. Having all of your eggs in one basket can mean that you really loose out if that particular investment goes the wrong way. Following the ‘low correlation’ principle, where you have multiple unrelated investments, is the best policy. This diversification means that if one area of your portfolio is decreasing in value it doesn’t necessarily mean that the other areas are too. Whilst diversification does not completely obliterate the risks it is one of the safest options.
Some Different Types of Assets
Bonds: Essentially bonds are I.O.Us or loans where you play the banker. Your money is loaned to either the government or a private company who promise to pay you back with interest. The amount on which the borrower pays interest is known as ‘face value’ and the date by which they have to pay you back is known as ‘maturity’. Normally a fixed interest rate or ‘coupon’ is paid to the lender at certain intervals or when the bond reaches maturity. There are a wide range of bonds to choose from with different levels of risk attached.
Shares: Contrary to what you may see in the latest Wall Street blockbuster, buying shares in a company is a fairly civilized process. Most of you will know that private individuals have a tax free savings amount, half of which can be placed in an ISA. However, did you also know that you can use that tax free allowance (£11, 280) for the purchase and trade of shares? With shares, you as an individual are trading your money for a piece of the company. The price of shares will increase and decrease due to demand. Whilst the term ‘shares’ refers to ownership in a particular company, ‘stocks’ is simply a term someone would use to describe their collective shares in multiple companies.
When seeking to start a diverse portfolio there are a number of ways to ensure that you get a more varied spread. We have already mentioned that buying shares in just one company is a no-no but it is also best not to invest in companies who all operate in the same sector. Different markets will flourish at different times and you need to make sure that your portfolio is balanced in order to make the most of/weather these fluctuations.
You could also look at investing in companies from different countries. Economies fluctuate and if your investments in the UK are down due to a recession you would want the security of knowing that your overseas investments were still stable. As many economies are closely tied by trade and other factors it is a good idea to consult a professional advisor for advice on which countries would complement each other well within your portfolio.
The Downsides of Diversification
As with any type of investment there is a level of risk associated. Those people for whom the risk pays off will reach their investment goals and sometimes much more besides. To a certain extent the degree of risk involved will often affect the amount of return an investor can expect to see. As we have already looked at, diversification can help to minimize this risk but too much diversification can spread your resources too thinly and minimize the rewards. Normally it is advisable to have no more than 20 different investments within your portfolio.
Vicky is a writer who has recently found an unexpected interest in the finance niche. She loves to read up on high profile IPO's as well as writing introductory articles for beginners.