Risk is a fundamental part of investing. While it can’t be completely avoided, there are ways you can manage it. One way to mitigate some risk is a process called diversification.
A diversified investment is one where you hold different types and mixes of assets (bonds, shares, property, cash etc.). By spreading your money across a number of asset classes you protect yourself should any one asset perform badly. Over time, a diversified investment typically helps you achieve smoother and more consistent returns. The way you diversify your investment will largely depend on three key factors:
Investors with a longer time horizon may feel more comfortable in taking on assets with more risk because they have time to offset any short-term market volatility. By contrast, investors with a shorter time horizon are less likely to be comfortable taking on risk, as they are more vulnerable to a short-term market loss.
Different asset classes carry varying degrees of potential risk and return. For simplicity, an investor might choose to adopt a conservative, moderate or aggressive approach when diversifying. A conservative investor will want to protect their initial investment (called capital protection) but this typically achieves lower returns. By contrast, an aggressive investor seeks much greater returns but exposes their initial investment to more risk. It’s also possible to change your risk profile. For instance, as your time horizon shortens it’s likely you will shift to a more conservative approach.
Your investment goal and time you have to achieve it plays a large part in deciding which sorts of assets you’re likely to choose. If you don’t include enough risk in your portfolio, you may run out of time to achieve your goal. Conversely, carry too much risk and your money might not be there when you want it due to a market downturn. As a general rule assets like cash, fixed interest and bonds have a lower risk profile while property and shares are higher risk.