When investing in financial markets, one of the principal considerations to think about is: how well spread are your investments?
It’s common to judge or compare investments based on the best-performing asset class at any given time, leading to questions about the value of diversification. In this article, we will explore why investment managers, like us, adopt this approach and highlight the advantages of this strategy.
What do we mean by diversification in investments? Instead of putting all your eggs in one basket or all your money into a single stock, diversification allows you to spread your investments across different assets and sectors, reducing your reliance on any one investment to drive your returns. Consequently this allows you to spread the risk considering different factors.
Diversification of investments is a method investment managers use to control the risk exposure within a portfolio. The way managers choose how to spread the risk will depend on their strategy and analysis, which comes from a deep understanding of financial markets. Here are some reasons as to why they will look to do this.
The first is risk reduction. Diversification helps spread your investments across different asset classes, industries, and geographic regions. By doing this, any poor performance of one investment or sector is less likely to have a dramatic impact on your overall portfolio. For example, if stocks in one sector perform poorly, other sectors might perform well, offsetting the losses.
Diversification also is used to smooth volatility. Different assets or investment categories tend to behave differently in various market conditions. While some investments may experience fluctuations in the short term, others, like bonds, could offer a more stable return. A diversified portfolio is likely to have less drastic swings than a portfolio concentrated in one area and therefore take away some of the emotion one has with investing, mitigating from having to time the market correctly – which is very difficult to do.
Opportunities across various sectors allow you to capitalise on growth in different areas of the market. For example, while tech stocks may be soaring, emerging markets or commodities could present opportunities that enhance your returns, even if one asset class is underperforming.
One critical factor that investment managers closely watch is asset valuations. While some sectors may be highly valued, others could be undervalued, presenting attractive entry points. By diversifying into these overlooked areas, you position yourself to capitalize on their long-term growth potential as their value may rise over time.
Diversifying and hedging against uncertainty when market conditions are unpredictable is also a very useful strategy. Political changes, economic downturns, and other events can affect specific industries or asset classes, particularly at the moment. Diversifying across different types of investments (stocks, bonds, commodities, etc.) helps to protect your portfolio from being overly exposed to any single risk. With the start of Donald Trump’s presidency, huge change is potentially just around the corner both politically and economically. Therefore, there’s even more reason to spread your nest eggs in different pots.
Diversification ultimately is an important tool for balancing risk with the pursuit of long-term growth. By owning a mix of investments, you can stay invested through various economic cycles without being overly affected by short-term losses, market shocks, or too much personal intervention.
When looking at a diversified portfolio, you might wonder why we have exposure to certain instruments that are performing less well at any given time. To bring the importance of diversification to life, one only has to look at the past. Take the dot-com bubble, for example – a stock market bubble that ballooned during the late-1990s and peaked in 2000. This period of market growth coincided with the widespread adoption of the World Wide Web and the internet, resulting in a dispensation of available venture capital and the rapid growth of valuations in new dot-com startups. The NASDAQ composite rose by an astonishing 800% from 1995 to 2000, but by 2002 the composite had lost over 75% of the gains made through the 5 preceding ‘bubble’ years.
More recently, a notable example is the 2020 Covid period, during which the Bailey Gifford US Growth Fund emerged as a top-performing fund. However, many investors caught wind of this, but most invested at the wrong time. This same fund then had a terrible time through 2022 and has struggled to really recover. We certainly recall speaking to a lot of our client base through this time and were often questioned about our diversification strategy altogether.
Through the latter stages of 2020, some clients were asking us why hadn’t we invested fully into this fund. As you can see from April 2020, the stock went up roughly an astonishing 250%, but then dramatically fell and lost the majority of its gain – and has struggled to recover ever since.
These past events highlight two key lessons. Firstly, timing the market becomes a lot more relevant when investing in one instrument – and most invest when they hear things are going well, at nearly the top of its performance.
The second is that you can more safely navigate the downside risk by diversifying your investments. Spreading your investments ensures exposure to some assets that can experience significant growth and others that are less likely to decline during turbulent markets, providing more consistent and predictable returns over the long term.
Investing can be an emotional rollercoaster. When you constantly compare your performance to others, it’s easy to make impulsive, often rash decisions. To avoid this, it’s crucial to stick to a clear goal and investment timeline, adjusting your risk tolerance accordingly. Understanding your comfort level with risk is key. Our well-diversified portfolios, managed by our expert Asset allocation team, can help you pursue your objectives in a more sustainable, realistic way, reducing the pressure of needing to be right and timing the market correctly. As always, you can reach out to our friendly team to discuss any of the points above – or anything else related to your financial situation.
*As with all investing, financial instruments involve inherent risks, including loss of capital, market fluctuations and liquidity risk. Past performance is no guarantee of future results. It is important to consider your risk tolerance and investment objectives before proceeding.
