In his latest Finance on Friday column for Altrincham Today, Joel Adams from LIFT-Financial looks at how to protect against the unexpected in your investment portfolio.
The shocking news that Tesco had over-stated its profits by £250m this week sent shockwaves through the City and saw the Tesco share price tumble – it is down 17% on the week so far and nearly 50% over the last 12 months.
But how can that be? Tesco is (still) the 31st biggest company in the UK and a well-established high street retailer who most of us will have used over the years. I can regularly be found filling a trolley in our own store in Altrincham, but I am a sucker for offers and vouchers and their marketing is designed to lure in gullible people like me!
From an investment perspective, without knowing about the current issues or the share price volatility, I would have thought that shares in Tesco plc would be a good investment. However, the volatility of the Tesco share price would suggest otherwise.
The fact is that it’s actually impossible for anyone to really know whether Tesco is a good, bad or indifferent investment with any certainty. Even the most talented of fund managers can’t get it right on a consistent basis and actually, as this week’s unpredictable news from Tesco demonstrates, you can never be in possession of all of the facts before you invest in a single company stock.
[blockquote cite=””]Many investors prefer to spread their money around different stocks, sectors, assets and even countries to achieve as much diversification as they can[/blockquote]
So how can investors avoid such unwelcome news having an impact on their portfolios? There is really only one way and that is to diversify your investments. By diversifying your portfolio, in effect, all of your eggs are not in one basket and so, if you drop the basket (or Tesco’s share price plummets!), they don’t all break.
The Nobel Prize-winning theory – written by Harry Markowitz – that drives many investors is known as “Modern Portfolio Theory”. It is actually just a mathematical representation of the concept of diversification.
Diversification can take many forms, and if you spread your investments around other retailers such as Sainsbury’s, Morrisons, M&S and Asda (Wal-Mart) your risk would be much lower. All are unlikely to have issues like Tesco’s at the same time, and as one of them would not always give you the best return on its own, your potential investment returns would also be higher.
Obviously investing in just one sector – retail in this example – can also be risky, so many investors prefer to spread their money around different stocks, sectors, assets and even countries to achieve as much diversification as they can.
The reality however is that most stocks are “correlated”, so if there is a stock market crash (as there has been many times in the past), all stocks fall in value together. Mixing in fixed interest investment like gilts and bonds, property, cash and “alternative” investments is therefore the only way to make sure your risk is as low as possible and your potential returns are maximised for the level of risk you are taking.
And how much should you invest in each area? Well, that is where the personalisation of an investment portfolio is key and where you will need advice to make sure you make the right decisions. All investments are not the same however and, as we will see next week, cost is a very big determining factor.