Keeping track of lots of individual assets can be a daunting task

Picking the right balance of assets for your portfolio depends upon your own risk profile. One way to protect your portfolio is to spread your risk by diversifying across several different types of investment funds and classes of securities and localities in order to distribute and control risk.

 

Different risk characteristics
There are many different assets in which you can invest, each with different risk characteristics. While the risks attributable to assets cannot be avoided, when managed collectively as part of a diversified portfolio, they can be diluted.

The main assets available are shares, bonds (also referred to as ‘fixed interest’), cash and property.

While individual assets have a bearing on the overall level of risk you are exposed to, the correlation between the assets has an even greater bearing. The aim is to select assets that behave in different ways, the theory being that when one is underperforming, the other is ‘outperforming’.

Fixed interest investments and property, for example, behave differently to share-based investments by offering lower, more consistent returns. This provides a ‘safety net’ by diversifying away from many of the risks associated with reliance upon one particular asset.

Spreading investments across different assets

Keeping track of lots of individual assets can be a daunting task. A much simpler solution is to acquire investment funds containing those assets and leave the diversification worries to professional management. By purchasing a fund that invests in, say, large blue chip companies, another that invests in smaller growth companies and others that invest overseas, you can spread investments across hundreds of different assets.

Reduce share-specific risk by diversifying

By diversifying within assets, you can spread your investments into different shares or bonds to ensure your portfolio is exposed to lots of different types of investments rather than, for example, having shares in just a few large companies. In this way, share-specific risk can be reduced should one of those companies experience difficulties.

Different sectors perform in very different ways

It is just as important to spread your investments across different sectors – areas of the economy where businesses share the same or a related product or service, for example, pharmaceuticals, telecommunications or retail – as well as different companies. Companies are classified by the sector in which they reside, which is dependent on the goods or services they sell or provide.

For many reasons, companies within different sectors perform in very different ways. By diversifying across sectors you can access shares with high growth expectations without over-exposing your portfolio as a whole to undue risk.

Greater geographical diversification can help
It’s natural to feel more comfortable investing a portfolio in your home market but this is not necessarily the most sensible option. Because investments in different geographical economies generally operate in different economic cycles, they have less than perfect correlation. That’s why greater geographical diversification can help to offset losses in a portfolio and help to achieve better returns over time.

Investments styles to suit your needs

This is another important aspect to consider when building an investment portfolio. Some investment funds use a ‘passive’ strategy. This is an investment approach that aims to mirror or ‘track’ the performance of a financial index. This is normally done by either investing in the exact constituents of an index or by taking a representative ‘sample’ of that index. The managers of such funds have lower expenses than active fund managers, and the charges to investors are therefore lower.

Other funds use an ‘active’ approach and aim to beat the index by using their own research and analysis to select shares they believe will achieve greater returns.

This information sets out the basics of portfolio diversification. It is not designed to be investment advice and should not be interpreted as such. Other factors will need to be taken into account before making an investment decision. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Past performance is not a guide to future performance