We are in the dying days of the ISA season and people are frantically putting money into new accounts before the deadline.
In search of higher returns than from a cash ISA, some people are turning to “stock & share” ISAs but wondering what to invest in within it…
The common answer brandied around for long-term investment success is “diversification”!
Diversification is achieved by choosing a mix of different kinds of investments. The goal of diversification is not necessarily to boost performance (it won’t ensure gains or guarantee against losses) but more to target a level of risk (based on your goals, time horizon, and tolerance for volatility) and to try and optimise returns for that level of risk.
To build a diversified portfolio, you should look for investments (stocks, bonds, cash, or others) whose returns have not historically moved in the same direction and to the same degree. This way, even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much. The most common way of investing is to invest in funds (or investment trusts, see my previous post) rather than individual stocks. A fund invests based on the philosophy and remit of its fund manager, who makes the decisions and manages the investments for you. The added advantage is that each fund is classified by investment category, for easy identification. The following broad fund categories are available:
Growth: Aim is for the fund price to increase because the underlying value of the company stocks held has grown so that in time the fund can be sold at a profit. Return: High, Risk: High.
Income: Aim is for the fund to provide investors with earnings from the dividends of the companies into which the fund is invested. Adding the value of these dividends to the slow growing fund value provides the profit. Return: High, Risk: Medium.
Fixed: Aim is for the fund to provide a reliable stream of income (like above) but from bonds, which are fixed term loans issued by companies and governments looking to raise money. Return: Low, Risk: Medium.
Mixed: Aim is for the fund to invest in a mixture of stocks and bonds, usually in a 80%/20% or 60%/40% mandated ratio. Return: Medium, Risk: Medium.
Total Return: A fund that tries to make positive returns over the medium-to-long-term and provide some growth when stock markets rise, as well as some shelter in falling markets. It invests in shares, bonds, cash, commodities and currencies and may use techniques like shorting and hedging. Return: Low, Risk: Medium.
Real Estate: A fund that invests in properties, usually commercial, or in companies that own, operate or finance income-producing real estate. Return: Medium, Risk: Low.
Cash / Short term debt: A fund that invests in cash or easy access short term debts, similar in some ways to a direct access savings account. Return: Low, Risk: Low.
A diversified portfolio consists of buying funds in each one of these categories so as to constitute your own “blend” of risk and return. My evaluation above for each category is a “stereotype” view and, like in everything, there is a wide variance within categories. In the end, it often depends on the Manager’s vision and ability.
To illustrate the benefits of a diversified approach, if we consider the performance of 3 hypothetical portfolios: a diversified portfolio of 70% stocks, 25% bonds, and 5% cash; an all-stock portfolio; and an all-cash portfolio. The diversified portfolio would lose less than an all-stock portfolio in a stock market downturn, and while it would trail in the subsequent recovery, it would easily outpace cash and would capture much of the market’s gains.
As can be seen, a diversified approach helps to manage risk, while maintaining exposure to market growth. I will explore how to diversify and some of the subtleties in a follow up post.
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