08 Spreading risk is the key

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Putting your eggs in different baskets

Predicting which shares are going to rise and which will fall is no easy task. No investor will be right all of the time. The world’s most famous investor Warren Buffett even bet $1 million that a selection of actively managed funds would not be able to outperform the US market average over a ten-year period. And you know what? He won the bet.

Portfolio diversification

While forecasting may be difficult, investors can take solace in the fact that diversification can help with this problem. Imagine your whole portfolio would consist of one share. If this company goes bankrupt or drops steeply in price, your entire investment portfolio will take a substantial loss. But with a well-diversified portfolio, the losses from one position can be made up for by the gains in another. This is the main benefit of diversification: the decrease of risk.

With proper diversification, it is not just about choosing multiple shares to invest in, but also considering other market factors that can affect your returns. If you would invest in Facebook, Twitter, and Alphabet, and the tech sector experiences a sudden decline in growth, it is likely that your entire portfolio will decrease in value. If you supplement those with stocks from the consumer goods, pharmaceutical, or construction sector, it can limit the exposure you have to a single industry.

Foreign investment

Investing does not need to stop at the border. A national recession can affect all sectors in a country, so one way to protect your investments from a domestic decline is to allocate some money internationally. With DEGIRO this can be done easily by investing across the more than 60 global markets offered on your trading platform. These include European exchanges like the LSE in London and the Xetra in Germany, as well as America’s New York Stock Exchange and the Tokyo Stock Exchange in Japan.

Timing your investment

The timing of your investment can also have a substantial impact on your returns. Here you see a graph of the American S&P500 index, with a peak in 2007, and a trough in 2009.

Rather than investing a single lump sum at once, thereby exposing yourself to the cost of your securities at a single point in time, you can instead opt to invest gradually over a longer period. By investing in smaller amounts, say on a monthly or quarterly basis, you will be less exposed to the price paid at time of investment but rather the investment will be averaged out across a longer time frame. This method is known as unit cost averaging.

To illustrate the effect of timing on your returns, we will compare the results of a £60.000 investment tracking the S&P 500 index, over a 5-year period. First, we see the investment if it was made at the best possible moment; the trough in 2009. The return would have been 105% over the course of the next five years. Had this same £60.000 investment been made just two years earlier, during the peak of the business cycle in 2007, your return would have been much different with negative yield of 5%.

Now the returns when instead of a lump sum investment, a monthly purchase of £1,000 is made for five years. While your return will still vary depending on the time in which you started, the results are much less extreme. This goes to show you that, by investing steadily over a longer time frame rather than trying to “time the market”, your returns can be much more consistent.

Coming up

When you diversify your investments and keep the portfolio for a long amount of time, it is possible to profit from the principal of compound interest. In the next lesson we will discuss what it is, and how to maximise its potential.