I know that if I want to reduce risk, I should diversify my investments. The warning to never put all my eggs in one basket always spring to mind. Well, here are a few ways how I’m diversifying my own portfolio.
Asset classes
The first thing I do is to make sure I’ve a good spread of assets. This means having exposure to stocks, bonds, property and cash. And yes I include a small amount of cash as it’s liquid.
It’s important to have a broad range of investments as each one will react differently to adverse events. Having a combination should reduce my portfolio’s overall volatility. The idea is that if some assets perform poorly then the others should offset this by delivering positive results.
Of course, I’m aware that there’s no guarantee this will happen. And even the professional fund managers that are paid to invest can’t get it right all the time.
Active versus passive
When it come to diversification, I’ll also look at how I’d like to gain exposure to a certain asset class. Here I’ll take the example of UK stocks as these are my primary focus. Rather than doing the hard work and picking individual stocks myself, I can diversify easily through active or passive management. But what does this mean?
Active investments include selecting investments trusts and funds. Here I’m paying fund managers to hold a portfolio of UK shares and make the decisions on which companies to buy and sell.
Even selecting my portfolio of direct UK stocks is considered as active management. This is because I’m actively selecting which shares I’d like to invest in.
Passive management includes investments such as Exchange Traded Funds (ETFs) or tracker funds. These securities typically track the underlying index. So for example, if I want exposure to the FTSE 100 index, rather than buying all the constituents of the UK’s leading stock market, I’d buy a FTSE 100 ETF. This could be one like the iShares FTSE 100 ETF but there are many others available too.
One thing to note here is that active investments are generally more expensive than their passive counterparts. So I always weigh up the pros and cons of each before dipping my toe in.
Location location location
I shouldn’t forget to mention that the location of my investments is also important. So when its comes to shares, I’m looking beyond UK companies to diversify my portfolio. I’d also include firms that are listed on US, Asian and European stock markets.
This is because, for example, volatility in the US stock markets may not affect European or Asian equities. This way I’m diversifying my exposure and minimising my risk.
While diversifying my portfolio reduces risk and volatility, it doesn’t always ensure positive returns. Investments can go up as well as down. They can fall especially when there’s a black swan event such as the coronavirus crisis.
But I know that this way gives me the best possible shot to maximise my returns.