The benefits of a diversified investment portfolio
Savings kept in the bank can assure the security of your money in all but the most extreme scenarios, but it remains highly exposed to the never removed threat of inflation.
Many worry about the devastation to prosperity that periods of high inflation can reap, but a more subtler loss can occur with gradual and moderate inflation if the returns you receive do not keep pace.
At the other end of the risk scale would be company shares, where if you are overly exposed, you can experience some heart wrenching losses from investment at the wrong time, at the wrong price.
The risks of the future can be mitigated by diversifying your investments; not putting all your eggs in one basket.
With a large amount of cash deposits, I would generally recommend that you split savings between three different banks, limiting the exposure to loss that you would occur if you held all your savings in a bank that experienced financial difficulty.
With company shares, research has shown that owning at least 21 different companies mitigates most of the business risk that can befall an individual company. What remains is the risk that applies to the whole stock market.
When you invest however, shares are not the only asset available to you; the four main types of investment assets are cash, bonds, property and shares. These promise a return (either interest, rental or dividend income), which is payment for the risk of loss and time preferences.
In any given year, it is extremely challenging to predict which asset class would provide the best return and which asset class is going to result in losses. Over extended periods of time, all the above asset classes are likely to provide a positive return, and all will have their moments of popularity or loss, however this is unlikely to take place at the same time.
The varying nature of investment returns can be mathematically measured using a concept known as correlation; professional investors use this to build a portfolio which reduces how much investments fluctuate (volatility), without entirely lowering returns.
By holding a portfolio which consists of cash, bonds, property and shares, you can ensure that your wealth is maintained and enhanced through most economic cycles. The exact allocation to each asset class will mostly depend on your risk profile, but also on tactical variations to your overall strategic allocation which are based on the prospects of an asset class at any given time.
Diversification will not remove all risk of loss. Importantly however, even in extreme scenarios, it would be almost impossible to experience a total loss of wealth (which can even apply to ‘safe’ bank deposits) and you can still benefit from having exposure to growth assets in the good times.
In summary, holding a diversified portfolio will mitigate the risk of loss and allow you to patiently build your prosperity.