It is essential to choose an investment portfolio commensurate with your attitude to investment risk. Risk is an implicit aspect to investing: investments can fall, economic conditions can change and companies can experience varying trading fortunes.
There are a wide variety of different asset classes available to invest in and commensurate risks attached to each one. Whilst these risks cannot be avoided, they can be mitigated as part of the overall investment portfolio, by diversifying.
By spreading your investments over a wide range of asset classes and different sectors, it is possible to avoid the risk that your portfolio becomes overly reliant on the performance of one particular asset class.
Key to diversification is selecting assets that behave in different ways. Some assets are said to be “negatively correlated”- for instance, corporate bonds and property often behave in a contrarian way to equities by offering lower, but less volatile returns. This provides a “safety net” by diversifying many of the risks associated with reliance upon only one asset.
It is also important to diversify across different “styles” of investing- such as growth or value investing as well as across different sizes of companies, different sectors and geographic regions. Growth stocks are held as investors believe their value is likely to significantly grow over the long term; whereas value shares are held since they are regarded as being cheaper than the intrinsic worth of the companies in which they represent a stake. By mixing styles which can out or underperform under different economic conditions the overall risk rating of the investment portfolio is reduced.
You can also spread risk by investing in different sized companies. Equity markets have a range of companies with different market capitalisation. The largest 100 companies by market cap comprise the FTSE 100. Many funds offer you the chance to invest in medium or small sized companies. By spreading your investment over the “cap spectrum” to include exposure to companies of different sizes you are avoiding being overly exposed to the largest companies in the market.
Some investment bonds offer access to multi-manager funds and this can be a way of spreading your risk by diversification whilst allowing the asset allocation decisions to be made on your behalf by a fund manager.
There are many different investment portfolio strategies used by investors. These include “core satellite” models where the bulk of a portfolio is held within a core portfolio with smaller “satellite” holdings in other types of asset. For instance, an investor may decide to hold a lower risk asset class as the “core” holding with smaller exposure to higher risk sectors as “satellite” investments. Other strategies include a “barbell” portfolio which is overweight with investments at the lower and higher risk areas of the investment spectrum and underweight in the medium risk sector.
Once an investment portfolio has been constructed many investors keep the individual funds under on-going monitoring and supervision. This can allow you to switch away from funds which are underperforming relative to their peers. It can also allow you to change the asset allocation to reflect the amount of risk you are prepared to take. If you are approaching retirement and need to rely on your investment bond to provide you with an income, you may have a lower tolerance for investment risk than a younger investor with longer investment time horizons.
On-going monitoring can also allow you to rebalance a portfolio. If a higher risk fund has outperformed and now represents a significantly higher percentage of your overall asset allocation than you first invested, switching some of the higher risk investment to lower risk funds to rebalance the portfolio can be prudent and help to consolidate investment gains.