You may think that becoming a successful self-directed investor is about making the right decisions all the time – but you’d be wrong. That’s simply not possible – nor is it necessary. You don’t need to win on every single investment you make to grow your wealth. The focus for any successful investor is the wider picture and a diversification strategy should be a key component.
While it may not be an ideal ingredient for great riches, adopting a sensible diversification strategy will enable the average self-directed investor to grow their wealth over the longer term. Placing all of your eggs in one basket will often lead to a boom or bust high risk strategy. Nice if the markets go in your favour, but catastrophic if they don’t.
Growing your wealth with a diversification strategy
If you are a long-term investor, then adopting a diversification strategy across asset classes – and by asset classes, I mean equities, bonds, commodities, property and cash – and geographical regions, will enable your portfolio to gain exposure to the best performing areas at any period of time, offsetting the impact of the poorest regional performers.
The table below highlights the performance of the major geographical regions around the world since 2007 to support the diversification model. Notice how the best and worst performing regions interchange each year – a good year is often followed by a less impressive one.
Table provided by Hargreaves Lansdown. Source: Lipper IM, calendar years for IA sectors
So, how does a diversification strategy help?
Adopting an investment diversification strategy provides two significant benefits over and above a more tactical strategy where the aim is to identify opportunities in order to buy low and sell high.
Reducing risk
Investors that adopt a broad geographical spread across a range of asset classes within their portfolio are significantly reducing their risk of loss over the long term. While there are inevitable periods of volatility in the financial markets, the underlying trend globally is one of growth.
As the table above shows over a ten year period, in times of sustained growth, there are some regions that significantly outperform others. In more volatile years, some regions have fallen far less significantly than others.
Take the financial crisis that began in 2007 as an example. While many of the world’s banking infrastructures were crumbling, Japan’s exposure was far less significant. As the full effects of the crisis were being felt worldwide in 2008, the UK lost 32.2% of its stock market value, the US 18.5%. The Japanese market meanwhile fell just 2.2%.
The following year, many regions gained back the ground they had lost the previous year – while Japan was the only region to lose out in 2009.
The value of compounding
Whether you are using Managed Funds, Exchange Traded Funds or your own mix of Equities, Bonds and Commodities to replicate this strategy, you are likely to be able to gain great benefit from the effect of compounding. That is to say, you’ll receive dividends from many of your purchases which, if re-invested will enable your investments to build significantly over time.
Whether the financial markets are experiencing growth or weakness, these re-invested dividends will boost your investments, while at the same time, providing you with further exposure to market growth.
During periods where the market is falling, these re-invested dividends will be purchased at lower prices. This will result in reducing the average purchase price of your investment and provide further growth should the market arrest its decline.
While a falling market can be a source of concern for many, for the successful self-directed investor, it can also provide opportunity for long-term gains.
