In times of market volatility, how can you try to manage risk while maximising opportunity for potential long-term reward?
One method is through diversification. We can’t control everything, so it can be useful to understand ways of managing risks in case the unexpected happens.
What types of diversification are there?
Simple diversification.
Simple diversification is a mixture of equities, cash and bonds. The disadvantage of this type of diversification is your risk isn’t as fully spread across different asset types in comparison to multi-asset and advanced diversification. However, there can be potential opportunities in individual investments – you just need to keep in mind that non-diversification can be risky as your eggs are all in one basket.
Multi-asset diversification.
Multi-asset diversification offers a full range of asset classes from one fund manager. Rather than buying individual funds that focus on a specific asset class, region or sector, you can buy individual multi-asset funds that contain an appropriate blend of different types of assets. If one individual asset in the fund is doing badly then the portfolio is unlikely to take a large hit from this. On the other hand, if one asset is doing very well then, the fund is unlikely to benefit significantly from this as it is likely to make up a small uncorrelated percentage of the fund. There may also be higher management fees associated with multi-asset diversification due to the high level of expertise required to put together and manage a multi-asset fund.
Advanced diversification.
Advanced diversification is a blend of multi-asset investment strategies that aims to find opportunities for potential growth. It goes to the next level of Multi-asset diversification, by also diversifying fund manager styles. Yet, whilst you can try manage risk through diversification, you need to be aware that investment risk still applies.
Understanding geographical diversification.
One of the key benefits of global diversification is the opportunity to mitigate risk.
Simply put, it involves not putting all of your eggs in one basket. While it’s common to invest in UK assets, the global market can offer diverse opportunities.
In an investment context, your investment may be split between regions, for example, the UK, USA and China. If one region underperforms, another region may do well, therefore holding funds invested in different geographical areas can further spread risk and protect investors from stock market corrections.
The value of your investment may fluctuate based on the exchange rate between the pound and foreign currencies.
Diversification won’t stop you experiencing losses, but it can help spread your overall risk.
The overall advantage is that your money is spread not just around the world, but also across industries and assets to give your money more potential opportunity to grow and mitigate exposure to a particular asset, which could increase risk of volatility. However, with just one fund manager, you are still limited to their thought process on how to diversify – there’s no diversification in terms of fund manager investment philosophy.
What are the risks and considerations when it comes to diversification?
Investors use risk diversification to help manage the risk of their portfolio by spreading investments across different assets and sectors.
It can be good to consider how the balance of assets in your overall portfolio reflect your appetite for risk and reward.
By investing in a variety of assets and asset classes, you are exposed to a range of potential growth opportunities. However, good performance is never guaranteed. Investing typically involves more risk than saving, as your money is exposed to the volatility of the markets you invest in. While there can be potential for greater returns you could also get back less money than you put in.
Having too many assets may dilute returns and make it challenging to manage your Portfolio effectively. This can also lose value during a broad market downturn, though the idea through diversification is to protect the losses from being as severe.
Changes in currency value can also impact returns when it comes to international assets. For example, if you maintain an investment portfolio abroad and the applicable currency declines in value, it is likely the value of the portfolio itself will.
Hedged funds can help manage this risk as investors tend to hedge portfolios of overseas equities and bonds to protect them against unforeseen foreign exchange losses. This makes sure that a portfolio does not forego any profits from equities or bonds due to currency losses.
On the other hand, as you build and manage your asset allocation, there are a few things to consider – time and risk tolerance. Time horizon involves the expected number of years you are considering investing to achieve a particular financial goal.
For example, a retirement goal may be around 25-30 years away, so as the time horizon here could be considered fairly long, you may be willing to take on additional risk in pursuit of potential long-term growth. This is taking into account the assumption that you’ll usually have time to regain lost ground in the event of any short-term market decline.
Why does diversification help in volatile markets?
Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This is designed to lower a portfolio’s overall risk against market volatility; however this can’t be guaranteed.
Our in-house investment management team can respond to changes in the market, working with our fund managers around the globe to structure your investments in response to what we are seeing in the global markets.
An investment can never just be a straight upward line of growth, there’s always going to be short-term fluctuations. Diversification works by giving you a wide range of exposure to parts of the market that may be performing better than others.
This century, we’ve experienced events ranging from the global financial crisis to the Covid-19 Pandemic and more recently, the invasion of Ukraine. While it can be unsettling to see an initial dip and sharp movement, realising that volatility is a normal part of investing can put investors’ minds at ease when the natural reaction is to panic.
Short-term volatility refers to the rapid fluctuations in asset prices typically over days or weeks. Over time, markets tend to recover from downturns and historically trend upwards, and so having a longer term time horizon can provide the opportunity for potential growth and compounding returns.
This long-term disciplined attitude and investing in diversified Portfolios could then give you the opportunity to do more with your money.
Understanding your investment time horizon is critical for choosing the right strategy, balancing risk and staying aligned with your financial goals.
Practical tips for building a diversified Portfolio.
Assess your risk tolerance.
Younger investors with a longer time horizon may prefer a more aggressive approach when it comes to risk. These types of investors may want to consider a portfolio more heavily weighted towards stocks, and a lower allocation to bonds, cash or other fixed-income assets. Pursuing higher returns, however, comes with an increased risk of loss.
On the other hand, those nearing retirement may favour a conservative mix with more bonds and aiming to manage risk.
Consider tax efficiency.
Making use of ISAs could help to maximise tax-free growth on dividends, capital gains and interest. There is a limit on how much you can pay into your ISAs each year. For the current tax year, the total ISA allowance is £20,000 across both Stocks and Shares and Cash ISAs.
Stay balanced and consider rebalancing regularly.
Rebalancing is the process of buying and selling portions of your portfolio to return it to its original allocation. Rebalancing helps to ensure that your portfolio is structured in a way that adheres to your investment strategy and risk profile.
It can also help you to stay disciplined and avoid making costly mistakes.
A long-term disciplined attitude and investing in diversified Portfolios could give you the opportunity to do more with your money. Over time, you may see that some investments outperform others, therefore rebalancing your portfolio could help restore an investment portfolio that matches your target asset allocation.
Seek professional advice.
If you’re not sure which investments to choose, you could seek financial advice.
With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. This material is not a personal recommendation or financial advice and the investments referred to may not be suitable for all investors.
ISA eligibility and tax rules apply. You should ensure your contribution does not result in your total ISA contribution within the tax year exceeding £20,000.
Tax is subject to an individual’s personal circumstances and tax rules can change at any time.
True Potential Wealth Management is authorised and regulated by the Financial Conduct Authority. FRN 529810. Registered in England and Wales as a Limited Liability Partnership No. OC356611.
True Potential Investments LLP is authorised and regulated by the Financial Conduct Authority. FRN 527444. Registered in England and Wales as a Limited Liability Partnership No. OC356027.
