Diversification – The Basics
Diversification is a word you will hear quite often when discussing investments with friends, family or investment professionals. It is a word that holds the key to the success of your portfolio and more specifically how well your portfolio handles the ups and downs we can all suffer from time to time.
With that in mind, you may be surprised to hear some people completely ignore it! So, we thought we would share with you a basic overview of diversification and highlight why it is so important.
What is diversification?
If you’ve ever heard the phrase “Don’t put all your eggs in one basket,” you probably have a good idea of what diversification means and why it is so important for protecting your assets. Diversification is simply the “act of introducing variety.” Though it can be used in several different context, when it comes to managing your money, there are two main places you should ensure you are using it — your income and your investments. Financial diversification helps reduce risk in your finances and is a fundamental part of making sure your financial goals aren’t derailed by the unexpected.
Why is diversification important?
When you consider what you want for your income, you probably think of only one thing — how high you want it to be. However, that’s certainly not the only aspect that matters when it comes to how your income impacts your net worth. How much you spend, how high your taxes are, how long you plan to work and several other factors can make the same income look very different. So can the source(s) of your income.
For example, take two people, John and Laura, who both earn £100,000 per year. John’s £100,000 comes from three different jobs plus rental income from a property he owns and lets out. Laura’s £100,000 all comes from her job in the form of a salary. If a recession hits the economy and Laura lost her job, she would lose £100,000 immediately whilst if John lost one of his jobs, he would still have three other sources of income and not be struggling to replace all his income at once. John is in a much better financial position than Laura.
Why should I diversify my investments?
The same idea holds true when thinking about investing. When you make an investment in your portfolio, you have several different asset classes that you can consider, such as real estate, stocks and bonds. Within those categories, you still have more options. For example, you could invest in U.K. or European stocks or corporate or government bonds.
Consider this: If, in 2008, you had invested 100 percent of your portfolio into one asset class, U.S. stocks, you wouldn’t have been very happy when your portfolio dropped 34 percent that year. However, different asset classes often move in different directions at the same time so, if you had diversified and invested 50 percent of your portfolio in bonds (some government and some corporate), your losses would have been closer to 17.5 percent. While still not ideal, someone who was properly diversified during 2008 would have been considerably happier with his performance than someone who was not.
Similarly, someone who had held 100 percent bonds the next year, in 2009, would have been frustrated by his 2 percent return compared to the 50/50 portfolio which returned over 10 percent! You never know which asset market is going to go up and which is going down so diversification gives you the best risk-adjusted return.
Diversifying your portfolio is more art than science because it depends on a variety of factors like your age, income streams and risk tolerance. However, spending the time to determine which ratio is right for you will pay big in the future.
Diversification in property?
While investing in property, the need for diversification is just as fundamental as anywhere else. Consider the same example above, if you held a property portfolio consisting of just one house valued at £300,000 and you suffer a rental void period or you have trouble selling, then your income or cash flow will seriously suffer. If you put that same £300,000 into a couple of smaller properties, maybe a property bond paying you regular interest, then if one aspect of your portfolio suffers a hiccup, the rest will keep you moving forward.
That’s why here at Property Stream we don’t simply offer investments in residential property. We aim to offer you different types of property investments, making it simple and straight-forward to diversify within a sector you understand.
Head over to our website for more information on the current opportunities on offer or alternatively click below and arrange a free consultation.
