08 Spreading risk is the key

Imagine your whole portfolio consists of stocks in one company. If this company goes bankrupt or drops steeply in price, your entire investment portfolio would take a substantial loss. It is therefore important to balance your portfolio wisely. This lesson will give you insights on how to reduce your risk by diversifying your portfolio.

Text version

a scale that represents spreading risk while investing.

Putting your eggs in different baskets

Predicting which shares are going to rise and which will fall is no easy task. No investor will be right all of the time. The world’s most famous investor Warren Buffett even bet $1 million that a selection of actively managed funds would not be able to outperform the US market average over a ten-year period. And you know what? He won the bet.

Warren buffet Hedge fun results 2017

Portfolio diversification

While forecasting may be difficult, investors can take solace in the fact that diversification can help with this problem. Imagine your whole portfolio would consist of one share. If this company goes bankrupt or drops steeply in price, your entire investment portfolio will take a substantial loss. But with a well-diversified portfolio, the losses from one position can be made up for by the gains in another. This is the main benefit of diversification: the decrease of risk.

Spread your investments into different sectors

With proper diversification, it is not just about choosing multiple shares to invest in, but also considering other market factors that can affect your returns. If you would invest in Facebook, Twitter, and Alphabet, and the tech sector experiences a sudden decline in growth, it is likely that your entire portfolio will decrease in value. If you supplement those with stocks from the consumer goods, pharmaceutical, or construction sector, it can limit the exposure you have to a single industry.

Spread your investments into different countries

Foreign investment

Investing does not need to stop at the border. A national recession can affect all sectors in a country, so one way to protect your investments from a domestic decline is to allocate some money internationally. With DEGIRO this can be done easily by investing across the more than 60 global markets offered on your trading platform. These include European exchanges like the LSE in London and the Xetra in Germany, as well as America’s New York Stock Exchange and the Tokyo Stock Exchange in Japan.

S&P 500 index graph movement through several years.

Timing your investment

The timing of your investment can also have a substantial impact on your returns. Here you see a graph of the American S&P500 index, with a peak in 2007, and a trough in 2009.

Rather than investing a single lump sum at once, thereby exposing yourself to the cost of your securities at a single point in time, you can instead opt to invest gradually over a longer period. By investing in smaller amounts, say on a monthly or quarterly basis, you will be less exposed to the price paid at time of investment but rather the investment will be averaged out across a longer time frame. This method is known as unit cost averaging.

S&P 500 index graph focusing on the timing of an investment.

To illustrate the effect of timing on your returns, we will compare the results of a £60.000 investment tracking the S&P 500 index, over a 5-year period. First, we see the investment if it was made at the best possible moment; the trough in 2009. The return would have been 105% over the course of the next five years. Had this same £60.000 investment been made just two years earlier, during the peak of the business cycle in 2007, your return would have been much different with negative yield of 5%.

5 years result projection depending on the moment when the investor bought his investment.

Now the returns when instead of a lump sum investment, a monthly purchase of £1,000 is made for five years. While your return will still vary depending on the time in which you started, the results are much less extreme. This goes to show you that, by investing steadily over a longer time frame rather than trying to “time the market”, your returns can be much more consistent.

Unit cost averaging result example over a period of 5 years.

Coming up

When you diversify your investments and keep the portfolio for a long amount of time, it is possible to profit from the principal of compound interest. In the next lesson we will discuss what it is, and how to maximise its potential.

Imagine your whole portfolio consists of stocks in one company. If this company goes bankrupt or drops steeply in price, your entire investment portfolio would take a substantial loss. It is therefore important to balance your portfolio wisely. This lesson will give you insights on how to reduce your risk by diversifying your portfolio.

Text version

a scale that represents spreading risk while investing.

Putting your eggs in different baskets

Predicting which shares are going to rise and which will fall is no easy task. No investor will be right all of the time. The world’s most famous investor Warren Buffett even bet $1 million that a selection of actively managed funds would not be able to outperform the US market average over a ten-year period. And you know what? He won the bet.

Warren buffet Hedge fun results 2017

Portfolio diversification

While forecasting may be difficult, investors can take solace in the fact that diversification can help with this problem. Imagine your whole portfolio would consist of one share. If this company goes bankrupt or drops steeply in price, your entire investment portfolio will take a substantial loss. But with a well-diversified portfolio, the losses from one position can be made up for by the gains in another. This is the main benefit of diversification: the decrease of risk.

Spread your investments into different sectors

With proper diversification, it is not just about choosing multiple shares to invest in, but also considering other market factors that can affect your returns. If you would invest in Facebook, Twitter, and Alphabet, and the tech sector experiences a sudden decline in growth, it is likely that your entire portfolio will decrease in value. If you supplement those with stocks from the consumer goods, pharmaceutical, or construction sector, it can limit the exposure you have to a single industry.

Spread your investments into different countries

Foreign investment

Investing does not need to stop at the border. A national recession can affect all sectors in a country, so one way to protect your investments from a domestic decline is to allocate some money internationally. With DEGIRO this can be done easily by investing across the more than 60 global markets offered on your trading platform. These include European exchanges like the LSE in London and the Xetra in Germany, as well as America’s New York Stock Exchange and the Tokyo Stock Exchange in Japan.

S&P 500 index graph movement through several years.

Timing your investment

The timing of your investment can also have a substantial impact on your returns. Here you see a graph of the American S&P500 index, with a peak in 2007, and a trough in 2009.

Rather than investing a single lump sum at once, thereby exposing yourself to the cost of your securities at a single point in time, you can instead opt to invest gradually over a longer period. By investing in smaller amounts, say on a monthly or quarterly basis, you will be less exposed to the price paid at time of investment but rather the investment will be averaged out across a longer time frame. This method is known as unit cost averaging.

S&P 500 index graph focusing on the timing of an investment.

To illustrate the effect of timing on your returns, we will compare the results of a £60.000 investment tracking the S&P 500 index, over a 5-year period. First, we see the investment if it was made at the best possible moment; the trough in 2009. The return would have been 105% over the course of the next five years. Had this same £60.000 investment been made just two years earlier, during the peak of the business cycle in 2007, your return would have been much different with negative yield of 5%.

5 years result projection depending on the moment when the investor bought his investment.

Now the returns when instead of a lump sum investment, a monthly purchase of £1,000 is made for five years. While your return will still vary depending on the time in which you started, the results are much less extreme. This goes to show you that, by investing steadily over a longer time frame rather than trying to “time the market”, your returns can be much more consistent.

Unit cost averaging result example over a period of 5 years.

Coming up

When you diversify your investments and keep the portfolio for a long amount of time, it is possible to profit from the principal of compound interest. In the next lesson we will discuss what it is, and how to maximise its potential.

backtotop

Your investment journey starts here

Open a free account and join over 2.5 million investors worldwide on our user-friendly platform.

Note:
Investing involves risks. You can lose (a part of) your invested funds. We advise you to only invest in financial products which match your knowledge and experience. This is not investment advice.

Investing places your capital at risk. Read our full warning here.

icon_close

We want to empower people to become the best investors they can be. By offering a universe of possibilities and choices on our user-friendly platform, we are removing barriers to make investing accessible to everyone: beginners or experts. You get access to a wide variety of products on more than 50 global exchanges to have the freedom to invest the way you like. In our world, you also get great value for money. So, without compromising an inch on the quality, security and range of our investment services, we offer incredibly low fees. Prioritising your needs has helped us become the leading European online broker. Our 2.5+ million clients and 100+ international awards are proof of our success.

flatexDEGIRO Bank Dutch Branch, trading under the name DEGIRO, is the Dutch branch of flatexDEGIRO Bank AG. flatexDEGIRO Bank AG is an overseas company primarily supervised by the German financial regulator (BaFin). In the Netherlands, flatexDEGIRO Bank Dutch Branch is registered with DNB and supervised by AFM and DNB.

This communication is issued on behalf of flatexDEGIRO Bank AG and has been approved as a financial promotion on 3rd August 2023, for the purposes of section 21 of the Financial Services Market Act 2000 (FSMA), by Resolution Compliance Limited which is authorised and regulated by the Financial Conduct Authority (FRN:574048). flatexDEGIRO Bank AG is an overseas firm which is not authorised by the Financial Conduct Authority. This means that the FCA Rules made under FSMA for the protection of retail clients do not apply to the services provided by flatexDEGIRO Bank AG but investors are instead protected under applicable German law and Dutch law rules that apply to flatexDEGIRO Bank AG. Investors are not protected by the UK Financial Services Compensation Scheme.