Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
At the start of lockdown, I got pretty into MasterChef and, in my boredom, a high-quality dish couldn’t help but put me in mind of a well-diversified portfolio. The despairing looks on John and Greg’s faces when presented with a plate which was overpowered by one flavour seemed to me just like the grimaces of investors whose portfolios are over-concentrated on one region or sector.
The idea that adding too much of one delicious ingredient can ruin a dish seems counterintuitive - how could your meal not be enhanced by a large dollop of mayonnaise? Well, like all things, sensible investing involves a degree of moderation.
It’s an unfortunate fact that while markets usually rise, they often fall too. Knowing how to use a well-diversified portfolio to prepare against that risk, and how to cope when your investments do underperform, can pay dividends over the long run.
Preparing through diversifying
Throughout my Young Money articles so far, I have assumed that investing is worthwhile, since over time your investments will grow and so generate favourable returns.
It’s been a fair assumption to make because, as history tells us, markets always tend to go up over time. Nevertheless, the COVID-19 crisis has left investors across the globe facing severe spikes, up and down, in the value of their savings. For them, the idea that their investments will grow over time has been severely challenged.
So, while investors certainly have good grounds for thinking they should see returns on their investments over their lifetimes, they’re still undoubtedly taking on an element of risk. One of the best ways to prepare against that risk is through diversifying your portfolio.
If you’ve read any of my previous pieces, you’ll know that I’m a fan of diversification - the process of allocating your money across different holdings, so that your portfolio is not reliant on the performance of just one asset.
It happens both at the level of a manager picking individual holdings for their fund, and of you selecting your own funds for your portfolio.
Funds often focus on just one asset class, so it’s the job of the manager to diversify within that class - often by investing across different sectors or geographies where performance is likely to vary.
But some funds do invest across asset classes, and funds like these can serve as a good stalwart to integrate into your portfolio - the ‘buttery biscuit base’ beneath your other holdings. The Fidelity Select 50 Balanced Fund invests across our experts’ Select 50 choice of favourite investments, incorporating a number of different asset classes, geographies and strategies.
When it comes to diversifying your own portfolio, it’s good to build around investments whose performance is unlikely to overlap.
Holding two equity funds which both invest in the US with similar strategies and holdings, for instance, isn’t much use for diversification purposes - if US equity markets tank, both funds are likely to underperform.
The ‘Goldilocks’ investors who look for just the right balance of different revenue streams put themselves in the best position to prepare for any one’s underperformance.
It’s also worth thinking more generally about the level of risk you’re willing to take with your portfolio. As young investors, we can generally afford to take on higher degrees of risk since we have longer for our investments to recoup any losses. But tempering riskier equity holdings with some bond or cash funds can help protect you against short-term hits.
No matter how well you prepare, the levels of return on your investments will occasionally fall. The truth is, markets drop all the time - fortunately, they tend to recover as well. Market movement like this is known as ‘volatility’, and while it can be frightening to log into your account and see lower numbers than you’re used to, the best thing you can do is to remain calm and remember that while most markets will experience periods of short-term volatility, over the long-term they are likely to maintain a steady, upwards path. Volatility is the price we pay for the long-term outperformance of equities over other assets.
Besides the long-term advantage that staying invested gives you, it also means you avoid panicking at times of sudden market drops - and at times of panic, we’re unlikely to make the best decisions.
At the start of this year when investors across the globe were waking up to increasingly distressing news of market volatility, many sold their investments in an effort to secure what they had left. What followed over May and June was a remarkable market recovery, as investors sought opportunities amid the widescale sell-offs and felt optimistic about further recovery as lockdowns eased, while those who had sold missed out.
No one could have known how the market would react (they still don't) - and that’s precisely the point. None of us know what’s going to happen in the short-term, but we all know that over the long-term, markets tend to keep on rising.
Keeping that long-term view at the front of your mind should help you look at short-term fluctuations as nothing more than mere blips on a much longer journey. Investing doesn’t get tougher than this, as Greg might say.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
What happens to my pension if I get made redundant?
Four important tips if you’re facing financial uncertainty