Posted on: 10 Jul, 19
Welcome to our Guide to Managing Investment Risk. One of the most effective ways to manage investment risk is to spread your money across a range of assets that, historically, have tended to perform differently in the same circumstances.
This is called ‘diversification’ – reducing the risk of your portfolio by choosing a mix of investments. In the most general sense, there are many adages: ‘Don’t put all of your eggs in one basket’, ‘Buy low, sell high’, and ‘Bears and bulls make money, but pigs get slaughtered’. While that sentiment certainly captures the essence of the issue, it provides little guidance on the practical implications of the role that diversification plays in a portfolio. And, ultimately, there is no such thing as a ‘one size fits all’ approach.
Different investors are at different stages in their life. Younger investors may have a longer time horizon for their investing than older investors. Risk tolerance is a personal choice, but it’s good to keep perspective on personal time horizons, and manage risk according to when access to funds from different assets is needed. If cash is needed in the near term, it is better to sell an asset when you want to sell it rather than when you have to sell it.
Under normal market conditions, diversification is an effective way to reduce risk.
If you hold just one investment and it performs badly, you could lose all of your money. If you hold a diversified portfolio with a variety of different investments, it’s much less likely that all of your investments will perform badly at the same time. The profits you earn on the investments that perform well offset the losses on those that perform poorly.
While it cannot guarantee against losses, diversifying your portfolio effectively – holding a blend of assets to help you navigate the volatility of markets – is vital to achieving your long-term financial goals whilst minimising risk.
Although you can diversify within one asset class – for instance, by holding shares (or equities) in several companies that operate in different sectors – this will fail to insulate you from systemic risks, such as international stock market volatility.
As well as investing across asset classes, you can further diversify by spreading your investments within asset classes. For instance, corporate bonds and government bonds can offer very different propositions, with the former tending to offer higher possible returns but with a higher risk of defaults, or bond repayments not being met by the issuer.
There are four main types of investment, known as ‘asset classes’. Each asset class has different characteristics and advantages and disadvantages for investors.
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