A balanced investment diet

Capital at Risk: The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

A balanced diet should include foods of many colours. If your shopping basket looks a bit beige, you’re probably not getting enough nutrients.

The same principles apply in the world of investing. We occasionally hear about a solitary miracle investment with a share price that just keeps growing, but these securities are vanishingly rare. Their bubbles also tend to burst, much like tech stocks after the millennium.

That’s why diversifying – or spreading risk – between stocks, bonds and other asset classes is important. The wider your diversification, the less likely you are to be affected when one stock takes a hit or there’s a general market downturn. In other words, a balanced diet keeps you in better shape for the long term.

Risk: Diversification and asset allocation may not fully protect you from market risk.

Being diversified is the opposite of owning securities that mirror each other’s behaviour. Stocks and bonds tend to have a negative correlation, for example, which means they traditionally move in opposite directions.¹ And when the US dollar falls in value, gold often goes up.² Also, a country’s stock market and the value of its currency usually have a negative correlation. When sterling hit rock bottom after the chancellor’s mini-budget in September 2022,³ the biggest UK companies generated revenue from overseas markets because the low currency made their products very competitive.⁴

So why does diversification matter? If you buy a portfolio of 100 UK companies, you might think you’re diversified and that if one stock falls it won’t affect the rest. However, if the stocks are in the same sector, they could all be affected by a single change to the law or an incident that spooks that market.

Even if your basket of stocks contains a mix of sectors like pharmaceuticals, technology and industrial companies, you could still be vulnerable if corporation tax is raised for these big organisations. This might affect shareholders’ confidence that the companies will continue to generate steady profits, so their share price could fall. In supermarket speak, this is the equivalent of buying cheese, yoghurt, butter and cream – you’ve got too much dairy.

So what happens if you invest in lots of small, medium and large companies across many sectors in the US, as well as a range of government bonds. You could still run into problems if you’re a UK-based investor and the dollar/sterling exchange rate shifts like it did after the mini-budget in September 2022, as this could seriously affect your returns.

In all these cases, diversification may help you achieve steady returns over the long term. Spreading your money between lots of different securities and asset classes reduces your risk profile. As a general rule of thumb, the greater the proportion of equities in a portfolio, the more volatile the investments could be and the greater the risk. Government bonds tend to be less risky but high yield or junk bonds could be riskier than owning shares in very large blue-chip companies, so investors must assess stocks and bonds on a case-by-case basis.

Historically, a typical portfolio for an investor with a cautious attitude to risk contained about 60% equities and 40% bonds, but the markets were spooked by global events in 2022 so it might be worth adding safer corporate bonds (company debt),⁵ gilts (government debt), commercial property, and even gold and oil to your portfolio. Although gold and the US dollar are seen as safe havens in uncertain economic times, they are unlikely to deliver sparkling returns.

Risk: Trading in derivatives on physical commodities is speculative and can be extremely volatile.

Market prices of derivatives on physical commodities can fluctuate rapidly based on numerous factors, including: changes in supply and demand relationships (whether actual, perceived, anticipated, unanticipated or unrealised), weather, trade, fiscal, monetary and exchange control programs, political and economic events and policies, disease, pestilence, technological developments, changes in interest rates, whether by through government action or market movements, and monetary and other governmental policies. The current or “spot” prices of physical commodities may also affect, in a volatile and inconsistent manner, the prices of futures contracts in respect of the relevant commodity.

Asset classes don’t always behave as expected of course. In the UK, gold demand fell by 5% in 2023 in the UK,⁶ while the price of oil plummeted during the pandemic from $70 per barrel to around $10.⁷ There were years of positive growth in much of Europe after the 2008 financial crisis,⁸ but the Russian invasion of Ukraine in early 2022 led to spiralling energy costs, supply-chain disruptions and double-digit inflation, all of which triggered uncertainty in the markets. However, markets tend to recover more quickly than people expect because full-blown crises such as the dot-com crash at the turn of the millennium and the global financial downturn in 2008 are the exception rather than the norm. Whatever the future holds, a diversified portfolio gives you a good chance of riding out any storm.

¹ Source: BIS quarterly review, The correlation of equity and bond returns, 4 December 2023
² Source: Investopedia, What drives the price of gold? 17 December 2023
³ Source: Pound Sterling Live, chart of GBP vs USD since 1976, 30 December 2022
⁴ Source: Bloomberg, chart of iShares Core FTSE 100 UCITS ETF, 30 December 2023
⁵ Source: Unbiased, Investing in corporate or government bonds, 11 December 2023
⁶ Source: Reuters, Gold demand down 5% in 2023, 30 January 2024
⁷ Source: Macrotrends, Brent crude oil prices, 3 January 2023
⁸ Source: IMF, Economic outlook in Europe, 13 October 2023