What is diversification?
The concept behind diversification is perhaps best summed up by the proverb, “Don’t put all your eggs in one basket”.
Essentially, diversification is an approach that involves combining a range of different investments to provide the best balance between the risk of loss and the potential for strong returns.
The idea being that if one or more of your investments underperform, the effect will be mitigated by returns from other assets in your portfolio.
Effective diversification involves selecting the different investment assets which make up your portfolio strategically, based not only on your investment goals and willingness to take risks but on an understanding of how the possible behaviour of different assets may complement each other.
For example, historically bonds (essentially a promise by a government to repay borrowed money plus a set rate of interest at a specified time) have tended to represent a safe investment when company shares, or equities, are dropping in value.
Consequently, including both bonds and equities in your portfolio in differing amounts can help create a balance between risk and return.
The implications for your investments
A common way to diversify your investments is to hold a mix of company shares, bonds and property, as the value of each is unlikely to move up and down in the same way at the same time.
You can also diversify your investments to some extent within a single asset class. For example, rather than investing solely in company shares from the UK, you could spread the risk by investing in the US or emerging markets such as China and India.
While diversification cannot guarantee protection from loss or ensure a return on your investment, it can be a valuable way of helping to provide more consistent portfolio performance across various economic backdrops.
What is Volatility?
One of the best-known maxims about money is that the value of an investment can go down as well as up.
Volatility relates directly to this idea, as it refers to how much and how often the price of an investment moves up and down over time.
It can be calculated statistically for a particular investment but is also used to talk generally about market behaviour.
Why does it matter?
Volatility is essentially a measurement of risk. As the balance of risk and reward is at the heart of investing, it is important to understand how it affects your investments.
Novice investors, in particular, are often made nervous by short-term volatility, which can lead to them selling or buying at the wrong moments.
If you are investing for the long term, short-term volatility should not necessarily be a concern, because over time prices will tend to show a more predictable pattern.
High volatility is associated with higher risk because it makes the value of an asset at any given time (and hence the right moment to buy or sell it) more challenging to judge.
However, it is worth keeping in mind that investors make money because of changes in the value of the assets they invest in, so by definition some degree of volatility is desirable.
Volatility of different asset types
Volatility can vary substantially from one investment to another. Understanding this can help you invest in a way that suits your readiness to take risks.
For instance, shares are generally considered quite volatile assets, while bonds issued by the governments of developed market countries such as the US and the UK are at the other end of the scale and are sometimes described as ‘safe haven’ assets.
Going further, shares in smaller and younger companies are likely to exhibit more volatility than well-established global corporates. At the same time, investments in emerging markets are more susceptible to volatility than more mature markets.
However, it should be remembered that these are generalisations, and no investment is immune from volatility.