Diversification – packing for a summer holiday
Spreading risk when investing, known as diversification, is much like packing for a British summer holiday.
Unlike skipping off for a fortnight of guaranteed sunshine in the Med, you never quite know what the weather will hold at home.
Heat wave? Cold snap? Torrential rain? Hit the jackpot with a combination of all three? All bets are off if you’re planning a summer break in Blighty. However obsessively you check the weather forecast, you might still end up shivering or soaked.
Packing for a British holiday
When it comes to packing, it’s not enough to stick a bikini and a kaftan in a beach bag.
Instead, your packing needs to cover all the options.
Pile sunglasses, suncream and swimsuits into your suitcase, in the hope of blazing sun on the beach. Pack the macs and umbrellas in case the skies open. Then squeeze in thick socks and extra layers, in case the thermometer plummets and you have to cope with the cold. By the time you’ve added sandals, stout shoes and wellies, it’s a wonder you can close your case.
Thinking of ditching excess baggage?
Now ideal world, you return home after two weeks of solid sunshine, and the only things you wore were T shirts and shorts. You might look at your bulging suitcase, and wonder why you packed all the extra stuff.
But if it tipped it down for an entire week, you’d be grateful for a raincoat. If the light sea breeze turned into a howling gale, you’d be glad you brought a jumper.
Just because you’re lucky enough to have a stunning summer one year, doesn’t mean it won’t be wet and windy next year. If you ditch all the excess baggage, you could end up regretting it. Investing is similar to British weather in that past performance is no guarantee of what might happen in future.
Investing whatever the weather
On the financial front, diversification is a way of spreading your money across different kinds of investments to cope with different conditions.
When the sun is shining on the stock market, you may be dazzled by the stocks and shares that have soared ahead, or the higher risk funds that have delivered double-digit returns. You may wish all your investments had done so well, and be tempted to ditch the boring old bonds, that haven’t grown anywhere near as much. Why bother keeping some of your investments in slow but steady cash, when you could strip your investments back to the excitement of emerging markets?
But if the stock market turns stormy, stocks and shares could plummet faster than a seaside sky can cloud over. In troubled times, bonds might suddenly look better in comparison, and cash is less likely to lose its value. You could then be really glad you packed your portfolio with a range of different assets, including bonds, cash and property-based investments, to shelter you from falling share prices.
Coping with different conditions
If you spread your money over a whole range of different kinds of assets, companies and countries, you will be much less affected by setbacks in any one area.
Sure, a spread of investments means some parts of your portfolio won’t perform as well others at any one time, just as sandals aren’t much use in in a rain storm, or a thick jumper on a hot day. However, the variety will help smooth any returns over the long term, just as packing for different weather conditions will help you survive your holiday in greater comfort.
Maybe it’s a short sharp shower, and your investments dip before bouncing back. But brace yourself for the possibility of a deeper, longer down turn. The FTSE 100 index of Britain’s biggest companies has fallen by about 50% twice this century. That may be a rare event – just as you’d be unlucky to face an entire fortnight of rain, even in England – but it’s still possible.
Diversification is all about preparing for your financial future whatever the weather.
Faith Archer is an award-winning personal finance journalist and also a money blogger at Much More With Less.