Your coffee break investment plan - Day 6: Having a range of eggs in your basket
No investment is a guaranteed route to riches - but while you can’t eliminate risk completely, you can manage it by having exposure to a broad range of assets. This is known as diversification.
The idea is that losses suffered in one area will be balanced out by gains elsewhere. Should your investments in equities – another name for shares - take a tumble, for example, you would hope that other your holdings, such as commercial property, rise in value.
This helps put a floor under your holdings and limits the risk of losing all your money in difficult periods. If the global financial crisis of 2008 has taught us anything it’s not to have all our financial eggs in one basket as it leaves us too vulnerable.
Proper asset allocation involves having the four main asset classes: equities (shares); bonds (loans to companies or governments; commercial property (shops, offices and industrial buildings), and cash, as well commodities (such as crude oil, metals, natural gas, and agricultural products). Further diversification can be achieved through exposure to a variety of sectors and regions of the world.
However, a golden rule when allocating to assets is to ignore fashions and trends, points out Andrew Merricks, head of research at Skerritt Consultants. Fashionable investment funds may enjoy short-term periods of stunning performance but these can just as easily come to an abrupt halt.
“Opt instead for managers and funds with sound, longer-term investment goals that offer an acceptable level of risk,” he says. “Marketing firms are good at coming up with branded portfolios so make sure you know what they are trying to achieve.”
For example, unless you have a strong desire to invest in a particular area, such as Latin America, it might be worth opting for a more general global equity fund that will give you exposure to a number of countries and companies.
Of course, even though the value of your investment may fall, a loss is only crystallized when it’s cashed in. Until then it’s only a loss on paper and there is always the possibility that your manager will turn that into a profit.
It’s also important to understand that your asset allocation is likely to change significantly over time as your financial goals change so you need to re-evaluate it regularly.
Darius McDermott, managing director of Chelsea Financial Services says: “When you are younger you’re likely to have a higher proportion of riskier assets as you have the time to ride out volatility in the hope of higher gains. As you get older you are likely to de-risk your portfolio so that your capital is better protected.”
Riskier assets would include a high exposure to equities, especially those focused on more unpredictable parts of the world. Although these offer the potential for higher gains they come with a health warning attached due to the increased risk of volatility – exposure to the ups and downs of the stock market.
Mr McDermott doesn’t believe in the traditional approach of de-risking completely in later life and says some equity exposure is needed. “We are living longer and need to fund our retirements so our portfolios still needs to grow,” he says. “If not we run the risk of running out of money.”
If you missed them, make sure you read the first articles in this series.
Also watch Moneywise editor Moira O’Neill interview Andy Parsons from The Share Centre about why you should start investing.
The term is interchangeable with stock exchange, and is a market that deals in securities where market forces determine the price of securities traded. Stockmarket can refer to a specific exchange in a specific country (such as the London Stock Exchange) or the combined global stockmarkets as a single entity. The first stockmarket was established in Amsterdam in 1602 and the first British stock exchange was founded in 1698.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
An interchangeable term for shares (UK) or stocks (US). Holders of equity shares in a company are entitled to the earnings and assets of a company after all the prior charges and demands on the company’s capital (chiefly its debts and liabilities) have been settled. To have equity in any asset is to own a piece of it, so holders of shares in a company effectively own a piece proportionate to the number of shares they hold. (See also Shares).
A term applied to raw materials (gold, oil) and foodstuffs (wheat, pork bellies) traded on exchanges throughout the world. Since no one really wants to transport all those heavy materials, what is actually traded are commodities futures contracts or options. These are agreements to buy or sell at an agreed price on a specific date. Because commodity prices are volatile, investing in futures is certainly not for the casual investor.