Missing the second level of diversification
One of the first investing principles you will learn about as an investing beginner is a diversification.
Diversification not only makes sense, but it’s relatively easy to achieve. By selecting a handful of funds, you can ensure that your money is spread across hundreds of individual investments in just a few clicks.
As you delve deeper into diversification theory, you will discover two elements:
- Diversification within an asset class
- Diversification between asset classes
What do I mean by this? Well diversifying within an asset class is buying more of the same. Spreading your money across 25 different companies equities rather than investing in only one company.
This is what most people picture when they think of diversification.
But building an investment portfolio is also about apportioning your money between different categories of investments altogether. Different asset classes could include:
- Equities (stocks and shares)
- Bonds
- Savings accounts
- Property
- Plus many more (see the last point of this article).
This is like a second layer of diversification. While spreading money across multiple companies may allow you to mitigate the impact of a specific bad news event or case of poor performance, spreading your money across multiple asset classes may allow you to mitigate the devastating impacts of market crashes.
This is because different asset classes behave differently under different economic scenarios. When interest rates fall, the prices of bonds will rise. A common cause of interest rate rises is a challenging economic environment – which has probably led to share price falls.
This means that an investor holding both bonds AND shares, may see the profits on their bond holdings partially offset the losses on their shares.
Looking for the wrong type of reassurance
Investing is all about taking a dive into the unknown. The future performance of the stock market will always be a mystery, whether I’m talking about the price movements over the next decade, the next week, or even the next minute!
Learning to be comfortable in that uncertainty cannot really be taught, only gradually accumulated with experience over time.
At the beginning of an investing journey, it is common for investors to feel deeply uncomfortable about this inability to foresee how an investment will pan out.
As a result, new investors can be very tempted by marketing materials which provide an unrealistic level of reassurance.
‘Aha! This is what I was looking for!” they may think, as they read about an ‘Industry leading investment team which has consistently outperformed the market.’
What they don’t realise is that the performance being described was caused by the team being in the right place at the right time in the economic cycle. All price surges eventually come to an end, and the cycle could have now turned against them.
Of course, I fully appreciate that if you are a fund manager and your fund has performed excellently over the last three years, you would want to underline that fact and shout about it as much as possible in your fund key facts document.
However I must warn investors that past performance is not a reliable predictor of future returns. The materials themselves will probably highlight this point – do not overlook it. That disclaimer is legally required for good reason.
If simply investing into funds with good past performance was a winning investment strategy, then every investor would do this. The very fact that financial experts don’t, should tell you a lot about how misleading an upward chart can be.
Stepping outside your comfort zone
Investing is an exciting activity, compared to other forms of personal finance such as loans and insurance.
It seems to share a sizable overlap with gambling, with the key difference being that there is no ‘house edge’ working against you. In fact, the longer you stay in the market, the more likely you will see a positive return. If only a blackjack table worked in the same way!
It would be a mistake to assume that all opportunities labelled as ‘investments’ come with the same promise of a positive return over long periods.
This does certainly apply to equities and bonds – both are financial instruments designed to provide investors with a fair return for giving their money to businesses to use in the course of their trade.
The same cannot however be said for investing in commodities, which are sometimes included in the same group of investable assets.
In contrast to equities, commodities are inactive and unproductive. A commodity which is bought to be held for a long period, will still consist of the same lump of material at the end of the period as it was at the beginning.
Capital which is lent to a business on the other hand, will grow over time if it is used to fund profitable activities.
There is no ‘inherent growth’ in commodities. If the price of a commodity has risen, this is due to temporary fluctuations in supply and demand for the good. This is not a reliable or concrete form of return – this price growth could completely reverse in the future if the supply and demand equation returns to its original state.
Investing in a business does carry risk of loss too. The fortunes of an individual business could falter. But overall, the business community does succeed. The accumulation of wealth across the corporate world is also underpinned by tangible things – the same business may have more stores, more employees, and the ability to generate more revenue compared to when you invested. This gives fundamental support to the higher share price.
