A Money Unspun understanding different asset classes for diversification

Impulsively “going all in” and investing your savings in the latest hot stock or high-risk cryptocurrency is obviously a bad idea.
But so is holding just one or two types of asset class.

Nobody wants to lose all their hard-earned money through uninformed investment decisions.
You want to grow your wealth steadily over time, with an acceptable level of risk. To do this, you should look to build a diversified portfolio.

In this no-nonsense guide, we’ll explore strategies that help you grow diversified wealth, helping you sleep easy, safe in the knowledge you’re not going to lose it all overnight.

WHAT IS PORTFOLIO DIVERSIFICATION AND WHY IT MATTERS
Most people know that it’s a good idea to diversify their portfolio, but the concept seems abstract. What do we mean by diversification exactly?

Diversification basically boils down to not “putting all your eggs in one basket”.
When you spread your eggs across different baskets, you spread out risk by not being overly reliant on just one or two assets. It’s a safety net. It doesn’t eliminate risk (that’s impossible in investing), but minimises it by holding a good mix of asset types that don’t all move together in terms of value.

Imagine having a mix of stocks, bonds, some real estate, a few commodities (such as gold), and a bit of cash. If the stock market takes a hit, it doesn’t mean your bonds, real estate, gold, and cash investments follow suit. Gold, for instance, is considered a safe haven asset with prices tending to rise if the stock market crashes.

You should try to avoid “correlation” – holding assets that tend to move in the same direction during challenging times. For example, let’s say you put all your savings into big tech stock. If the tech sector catches a cold, your whole portfolio drops at the same time, amplifying your losses.

Diversifying your portfolio prevents drastic losses and leads to smoother returns. To do it well, you should look to pair stock and bonds with other asset class types, thus offsetting losses if one type dips.

UNDERSTANDING DIFFERENT ASSET CLASSES
If you want to build a diverse portfolio that matches your investment goals, first you must understand the different asset class types.

• Stocks (Equities): Stocks give you part ownership in a company, so if the company performs well, your stock value increases. They usually provide higher returns than other asset classes over the long term. But they’re also more volatile, leading to bigger swings and higher risk. You might want to reduce the amount of equities you hold if you’re investing for shorter-term goals.
• Bonds: Bonds help stabilise your portfolio as they’re generally less volatile. Bonds are loans to corporations or governments that provide regular interest payments. They tend to yield lower returns than stocks, but are more predictable income and help preserve capital during market downturns. You might want to boost the amount of bonds if you’re getting close to retirement or prioritise stability over returns.
• Mutual Funds and ETFs: These are pooled investment vehicles that let you invest in a broad range of assets within a single product. They’re usually made up of stocks, bonds, or a combination of the two types. Mutual funds are managed by professionals who aim to beat the market. ETFs (exchange-traded funds) follow an index, making them more cost-effective.
• Derivatives: Derivatives are contracts that change based on asset performance of stocks, bonds, or commodities. Options and futures contracts are the two most common types. Derivatives are riskier and more complex, but are useful for hedging (protecting against losses) or speculating on an asset’s future value.
• Cash & Cash Equivalents: Cash and cash equivalents, e.g. savings accounts or money market funds, are highly liquid. They’re safe and easy to access if you need them, but the trade-off is lower returns. They won’t add a lot to wealth growth as other types, but it’s still a good idea to hold a small amount to cover emergencies.
• Real Estate: Real estate gives you income in the form of rent and capital growth. It’s also less correlated with stocks, which helps spread out risk, but you have to factor in management costs, maintenance, and the risk of market fluctuations. Property is a longer term commitment and not as liquid as other asset types.
• Commodities: Assets like gold, oil, and agricultural products have different performance drivers than stocks or bonds. For example, gold usually does well when markets are struggling. Commodity prices are often volatile, as they depend on supply and demand, and can be hit by geopolitical events. The main advantage is that they protect against inflation.
• Alternative Investments: Hedge funds, private equity, cryptocurrency, etc. are higher risk, but offer higher potential returns. You might not be able to cash them out quickly, but they’re often uncorrelated with traditional asset classes, thus adding extra diversification. It’s not a good idea to hold too many of these, unless you’re an experienced investor or have a high tolerance for risk.

The amount of each asset type you should hold to maintain a diverse portfolio depends on your personal circumstances and savings goals. As an example, if you’re saving for long-term goals – a financially secure retirement for example – then you might want to consider something like the following proportions for your investment portfolio.

• Stocks: 50%
• Bonds: 30%
• Real Estate: 10%
• Commodities: 5%
• Cash & Cash Equivalents: 3%
• Alternative Investments: 2%

Please note that this is only an example. If you want a carefully crafted diverse portfolio, then speaking to an expert financial adviser is recommended.

BUILDING A DIVERSIFIED PORTFOLIO
Step 1: Define Investment Goals and Constraints
The first step is to work out what you want. Are you saving for a comfortable retirement? Or perhaps you’re looking to save a deposit to buy a home. Once you’ve got your destination in mind, it’s easier to plan the route, allocate assets, decide on a comfortable level of risk, and build a portfolio that works for you. For example, if you’re aiming for long-term retirement savings, you might tolerate more risk than if you’re saving for a down payment on a property in five years.

Step 2: Strategic Asset Allocation
Strategic asset allocation means balancing your portfolio with different asset classes. Base your strategy on the level of risk you’re willing to accept and the returns you’re hoping to achieve. If you’re young and have a higher tolerance for risk, you might lean more towards equities for rapid growth. If you’re close to retirement, put more into bonds for extra stability.

Step 3: Sub-Asset Allocation
Sub-asset allocation adds variety to each asset class. Instead of holding just one type of stock, you could diversify across different sectors like tech, healthcare, retail, and energy. In terms of bonds, you might choose a mix of short-term, intermediate, and long-term maturities to balance the potential risk and return.

Step 4: Active vs. Passive Funds
Passive funds, e.g. index funds, track a specific market index and aim to match its performance. Active funds are looked after by a fund manager who chooses investments based on research and insights, with the aim of outperforming the market. Combining both passive and active funds is a good balanced approach. Passive funds keep your costs low, while active funds add potential for extra returns, especially in niche market sectors where active managers have an edge, such as biotechnology, artificial intelligence, and other emerging markets.

Step 5: Rebalancing
Rebalancing helps maintain your target asset allocation as markets fluctuate. If certain stocks do very well, they’ll start to make up a bigger percentage of your portfolio, increasing your risk exposure. Rebalancing once or twice a year, means selling off some of the “winners” and buying into the “laggards”. This brings your allocation back to its original mix, realigning with your risk tolerance and goals.

ALTERNATIVE INVESTMENTS FOR ADDITIONAL DIVERSIFICATION
Alternative investments have different risk and return profiles, which means they can provide a stability boost to your portfolio. Popular alternatives are things like private equity, hedge funds, and collectibles like art, rare coins, or classic cars.

Private equity involves investing directly in private companies. Collectibles add a unique element, as their value isn’t typically linked to financial markets, instead fluctuating based on demand from other collectors.

Alternatives add a layer of resilience because they don’t always respond to economic events in the same way as stocks or bonds. Let’s say the stock market is down. A piece of fine art might even appreciate in value. This ‘uncorrelated’ behaviour, where one type of asset goes up or stays stable when others go down, helps smooth out your portfolio’s performance.

Many alternative investments, like private equity and hedge funds, have high minimums, often tens of thousands of pounds or more. However, these days there are platforms that “fractionalise” investments, which means you can buy a smaller piece of a larger asset, or investment funds that bundle various alternative assets.

How much of your portfolio you should put into alternatives depends on your risk tolerance and goals. For most people, alternatives might make up 5 to 20% of their portfolio. They’re meant to complement traditional investments rather than replace them entirely, so keeping them to a moderate portion of your overall portfolio is generally a good approach.

On the downside, alternative investments tend to be less liquid. This means they’re harder to sell quickly if you need cash. The fees might be higher too and may not be as transparent as stocks or bonds. For example, hedge funds charge higher management fees and private equity investments might be tied up for years.

WHEN AND HOW TO REASSESS YOUR PORTFOLIO
How often should you review your portfolio to keep it on track?

Generally, a yearly review is a good standard. Checking in annually keeps your portfolio aligned with your goals. It also stops you from taking on more risk than you’re comfortable with.

If you’re going through significant life changes, such as starting a new job, getting married,  buying a home, having children, or nearing retirement, it might be wise to review your portfolio more often.

A portfolio review looks at a few main things:

• Your investment goals
• Current allocations
• Market performance
• Growth of different asset types
• How well balanced your portfolio is
• Have there been any windfalls, such as a large inheritance

It’s a good idea to assess your strategy with a financial adviser.  Advisers are skilled in spotting shifts in market trends and rebalancing portfolios to protect and grow your investments. They’re also tuned into tax-efficient strategies, which means your returns can be optimised while avoiding unnecessary tax hits.

If you want an in-depth assessment of your investment goals and portfolio, get in touch with one of our expert advisers today.

We can help make sure your strategy is on track with a good mix of different asset classes, for whatever stage of life you’re at.