Why diversification is key when inflation rises

To stay ahead of rising costs and maintain your assets’ purchasing power, your portfolio needs to provide positive returns. Diversification can help you achieve this.

What is diversification?
Diversification is investment jargon for the well-known proverb: “don’t put all of your eggs in one basket”. While a well-diversified portfolio doesn’t give you guaranteed downside protection, it can help you maximise long-term growth potential. Since the values of different types of assets don’t always behave the same way or move in the same direction, holding a range of different investments can help reduce your risk.

Balance between risk and reward
The balance between risk and reward should be front of mind – diversification is key to this.

Protect your downside
When global events provoke market volatility, a well-diversified portfolio can help protect your downside. When Russia’s invasion of Ukraine caused volatility, some markets were more severely affected than others. Had you invested the majority of your money in Europe, you would have suffered far greater potential losses than if your portfolio had been invested across all regions.

4 main asset classes for a well-diversified portfolio
Spreading your wealth over different asset classes should achieve a strong, well-balanced portfolio.

Secure and easily accessible, cash is generally considered to be the safest asset. However, it tends to provide lower long-term returns than other asset classes and its value can be eroded by inflation.

Bonds are a loan you make to a company or organisation from which you receive interest payments. While usually considered medium risk, this depends on who is issuing them.

Equities (or shares)
Equities are an ownership stake in an individual company listed on a stock market index – the FTSE 100 in the UK or the S&P 500 in the US, for example. Many investors hold equity assets in funds, such as pensions, ISAs, or unit trusts, which are often pooled or collective investments. Investing in individual companies tends to carry more risk, so a collective approach can be extremely beneficial, especially since funds are looked after by professional managers. Because your money is pooled with other investors, you can often access a range of investments that might otherwise be unavailable.

While history shouldn’t be considered a guide to the future, over the longer term equities tend to outperform other types of investment. Shares can be volatile. Their value can go up as well as down and you may not get back the full amount invested.

Alternative investments
Property is one alternative investment. Its returns tend not to closely correlate with those of shares or bonds, which may be useful if you want to introduce another source of potential capital growth and income into your portfolio.

While property tends to be less volatile than equity or bonds, its value can fall as well as rise and is also less liquid; it

can take longer to invest into and sell when you want to access your money.

Other alternative investments include:

  • Infrastructure funds (large, high cost projects, often connected to public development of core systems such as transportation or electrical supply)
  • Natural resources (companies that are involved in the extraction of oil, gas, coal, metals, etc.).

Diversification is more than just the type of asset held
You can also diversify across:

  • Geographical regions – the US, UK, Europe, or Asia
  • Sectors – finance, energy, or transport
  • Themes – technology, healthcare, or renewable energy
  • Size – smaller companies (small cap) or larger companies (large cap).

3 reasons diversification is key
A well-diversified portfolio can help you:

1. Minimise risk and increase potential returns
Diversification spreads risk and helps to limit the impact of market volatility on your investments. When one sector, asset class, or geographical area falls, a rise in another area could help to offset the loss.

2. Provide greater opportunity for returns and eliminate investment biased
Diversification can help prevent you from falling foul of investment biases. You may be overly confident about the performance of sectors you know, or geographical regions that you’re familiar with. These unconscious biases could see you miss out on potential growth, whereas a diversified portfolio won’t be constrained.

3. Help you to consolidate gains
As your investment goal approaches, you might want to consolidate your gains. Diversification allows you to do this by rebalancing, increasing the number of lower-risk assets you hold. This should help to avoid the value of your investments suddenly falling in value when you need to withdraw funds.

Get in touch
If you want to ensure that your portfolio is well-diversified and balanced according to your financial goals, we can help. Please get in touch to arrange a time to chat.

The value of investments and any income from them can fall as well as rise and you may not get back the original amount invested. Past performance is not a guide to future performance and should not be relied upon.

Approved by The Openwork Partnership on 28/03/2023