Diversification demystified

By Lisa Walls-Hester on Wednesday 4 May 2016

Alternative Lending

Businesses fail. Start-ups and small businesses are the most at risk from failure and according to the Office for National Statistics, 50-70 percent of all new enterprises set up in the U.K. fail within five years.

These figures are further backed-up with evidence from the AltFi 2015 report, Where are they now? which found that 20 percent of the companies that crowdfunded between 2011 and 2013 are no longer trading. Simply put, if we invest in one company it is highly likely that we will lose our money – which leads to the question, with such a high failure rate why would anyone want to invest in a small business? After all, an investment is supposed to be a vehicle that offers us a return, whether that’s as income or appreciation in value.

Experienced investors have some tools in their arsenals that reduce investment risks. One of them is diversification. It is the practice of spreading your money across a variety of investments so that a failure in one investment will not be disastrous to your overall financial position.

The aim is to get a balanced portfolio and by including many different types of investments we are more likely to get a more consistent return. The value of an investment can be impacted by economic conditions and different investment types react in varying degrees. By diversifying, we make these differences in performance work for us.

How to build a diversified portfolio?

Diversification means spreading your investment across different industries and different companies. Choosing investments with different stages of maturity and different operating markets also spreads the risk.

Common Industry Categories

Energy, Financials, Materials, Industrials, Utilities, Technology, Telecoms, Services, Consumer goods, Health Care

A fully diversified portfolio should include a mix of equity and lending and both short and long-term investments. Peer to peer lending and equity crowdfunding could make up a portion of any wider investment portfolio. The optimum number of investments you should hold differs depending on who you ask. A professional investor might recommend a limit of five percent for any individual investment in a portfolio.

Within the P2P portion of your portfolio, it is possible to achieve significant diversification. How you do that will depend on the platform that you’re investing in. Some platforms, such as Zopa and RateSetter, diversify your funds automatically by lending your money to many borrowers or through the use of contingency funds. On other platforms, such as Funding Circle, investors need to diversify themselves. Funding Circle recommends investors lend to a minimum of 100 borrowers for the most consistent returns.

So if you have £5,000 available to invest in a P2P or equity crowdfunding platform then £250 is a good limit for any single stock, loan or bond.

For part-time or hobby investors this would take a lot of time and effort to administer. The total number of investments you own is less important than how diverse the investments are.

We all have different investing goals and when you are developing your investment strategy you should take into account your own financial situation. This not only includes the total amount of disposable income you have to invest and your appetite for risk but also your requirement for liquidity (the ease of which you can get the cash back into your bank account, should an emergency crop up) and your personal aspiration for capital growth or income from your investments. For example, buying equity in a private company means that the money is likely to be tied up for many years. Equity crowdfunding is also at the higher end of the risk spectrum.

Being a disciplined investor isn’t always easy. The urge to go with our gut instinct or stick to companies in sectors we know about and like is strong. In addition, it is tempting to add more funds to a company that is performing well. But if you are funding companies with the objective of generating wealth then make a portfolio plan and stick to it.

Diversification is not a one-time exercise, it is an ongoing process and should be reviewed periodically or when a new investment is added or realised (sold).

Giving your portfolio a regular check-up will keep you focused on the big picture … we invest to earn profits.

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