The importance of balance

Written by MiP

Constructing a good, well-balanced portfolio is vital. If investors could predict the future, building a portfolio of investments would be relatively easy. They would back the stocks that will rise in value and avoid the ones due to fall. Unfortunately, predicting the future isn't that simple.

In order to dampen the risks of finding themselves metaphorically entirely on black, when the ball drops on red, investors need to build a diversified portfolio. This means including different sectors as well as different regions, such as the US, UK and emerging markets. This means that if one area is doing badly, it should be offset by another area doing well.

Different risks

Each area will have a different level of risk. For example, in the worst period for stock markets, an investor in the UK market will have lost around 30% from peak to trough, but some areas did considerably better, and some considerably worse. The US market, for example, recovered quickly, while emerging markets took some time to heal.

To make things more complicated the risk in an asset class will change over time. For example, an asset class will become more risky when it is more expensive. The clearest example of this was during the technology boom - technology stocks moved up very far, very fast and by the end carried a lot of risk for investors.

When to take more risk

Higher risk investments will be more suited to those investors with a longer time horizon, more propensity to take risk, or simply that can afford to run the risk of some capital loss in their portfolio in the hope of a higher long-term reward. These investors will have a higher proportion of their portfolio in riskier assets, which might mean more exposure to shares, and within their share portfolio more exposure to smaller companies or emerging markets.

Lower risk investments will be suited to those with a shorter time horizon, who are uncomfortable with taking risk with their money, or cannot afford to run the risk of capital loss in their portfolios. These people will have a higher weighting to lower risk assets, such as corporate or government bonds and blue-chip, larger capitalisation shares.

The key for investors is always to sustain a balance. That way, during the difficult times, they won't be too exposed to one particular area, and should see a more consistent return over time.

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