How to manage investment risk

6 steps to successful investing: #4 Spread your risk

Are you putting all your eggs in one basket? Managing investment risk comes down largely to one thing: diversification. Spreading your risk is the fourth step in the Six Steps to Successful Investing series, and while it may sound like plain common sense, you'd be amazed how many investors, even professional ones, forget it.

In this video, you'll learn why a healthy portfolio, much like a healthy diet, should include a range of different assets rather than a concentrated few. The main reason to diversify is to avoid being too heavily exposed to any single stock, sector, country or asset class. A second reason is to reduce volatility. Historically, equities have produced higher returns than bonds or cash, but in the short term share prices can swing sharply. Holding bonds alongside equities, and cash too if you're particularly cautious, can smooth the ride toward your investment goals.

You'll also learn what the Periodic Table of Investment Returns, produced each year by Callan Associates, reveals about markets. With each asset class colour-coded and each column showing a single year's returns from best at the top to worst at the bottom, the table makes one thing strikingly clear: there are no reliable patterns or trends to exploit. This year's top performer often becomes next year's biggest loser. Over the long term, though, it also shows how asset class performance tends to revert to the mean, which is why trying to predict the winners is such a losing game.

The takeaway: holding the whole market removes the guesswork, saving you time, money and unnecessary anxiety. The fourth step to successful investing is simply to spread your risk, building a diversified portfolio that isn't dependent on any single bet paying off.

Chapters / Key points

• Why you should never put all your eggs in one basket
• Why even professional investors forget to diversify
• The healthy-diet analogy for a healthy portfolio
• The main reason to diversify: avoiding concentration risk
• The second reason: reducing volatility
• How bonds and cash can smooth the ride alongside equities
• What the Periodic Table of Investment Returns shows
• Why there are no reliable patterns to exploit
• Why performance reverts to the mean over the long term
• Why holding the whole market removes the guesswork

Transcript

Six steps to successful investing #4: Spread your risk

It would seem common sense not to put all your eggs in one basket, but you'd be amazed at how many investors, even professional ones, forget.

Just as a healthy diet means eating a range of different foods, a healthy portfolio should include a number of different assets.

The main reason for diversifying is to avoid the risk of being too heavily concentrated in one particular stock, sector, country or asset class.

Another reason is to reduce volatility. Historically, equities have produced higher returns than bonds or cash. But in the short term, share prices can be very volatile.

So, holding bonds, and if you're very cautious, cash, in your portfolio alongside equities can smooth the ride to your investment goals.

This is the Periodic Table of Investment Returns, produced each year by Callan Associates. The asset classes are colour-coded, and each column illustrates the returns for a particular year, the best performer at the top, the worst at the bottom.

The table shows us there are no reliable patterns or trends you can take advantage of. This year's top performer often turns into next year's biggest loser. However, it also demonstrates how, over the long term, asset class performance tends to revert to the mean.

Holding the whole market removes the need for guesswork, saving you time, money and unnecessary anxiety.

So the fourth step to successful investing is to spread your risk.