Diversifying your personal finances
By Edward Backhouse
Putting a financial plan together is vital for your financial future, and within this, there are many layers of diversification that can help you to achieve a better outcome, i.e., being closer to your financial independence day (when you are working because you want to not because you have to) or being able to spend more in retirement.
Income
Diversification of income is also important in your retirement i.e., from your state pensions, investments, defined contribution pensions, cash or even defined benefit pensions and rental income. It is important to look at everything holistically to make sure your assets are working as hard as possible for you. Cashflow analysis helps to underpin what your financial future looks like.
Here is an example of a piece of cashflow analysis software with a variety of different incomes helping the clients to be more financially secure in retirement. This can also help to mitigate tax such as utilizing tax free ISAs alongside pensions which are 25% tax free to draw the income you need from your portfolio in the most tax efficient manner.
Cashflow planning can help to identify any shortfalls in your arrangements and take remedial action. It’s crucial to periodically review and rebalance your income sources to maintain the desired balance as your circumstances change over time.
Assets
It is important to have a mix of liquid and illiquid assets in one’s portfolio. Liquid assets such as cash, savings accounts, and money market funds can provide you with immediate access to capital in case of an emergency. Typically, one should have an emergency fund of 3-6 months’ worth of expenditure, plus anything earmarked for purchases in the next 2-3 years (you cannot stomach taking investment risk within this short time horizon).
As the investment time horizon increases you can afford to potentially take a higher amount of risk. For example, if you are in your 30s, your pensions are likely to be invested in a higher risk portfolio than something who is 60 and about to stop work and draw from them.
Should you be without/limited on liquid assets, and everything is tied up into one asset whether it be a BTL property, farm etc. there is a risk should you need immediate access to capital. We need to make sure you have an adequate emergency fund, and your remaining portfolio is working hard for you alongside this – hopefully to counteract inflation.
Investing in the great companies of the world in the form of global equities can be a great long-term way to invest as shown below however markets rise and fall and making sure that you don’t need to sell your investments at a poor time is going to be vital so your long-term financial planning aspirations remain on track.
It’s important to have a balance between the two to ensure that you have enough liquidity to meet your short-term needs while also earning higher returns on your long-term investments.
Investing in alternative asset classes, such as real estate or commodities, could also be considered to further diversify your portfolio, if appropriate for your risk tolerance and investment objectives.
Investments
This involves spreading your investments across different asset classes, industries, and geographic regions to reduce the overall risk of an investment portfolio. The idea is that by holding a variety of investments, the poor performance of any one investment potentially can be offset by the better performance of another, leading to a more consistent overall return.
A typical portfolio will likely have a fairly large portion of equities and fixed interest even some other asset classes including property and even cash.
We can potentially reduce risk through investment diversification, but it is important to distinguish between systematic and unsystematic risk.
- Systematic risk is also known as market risk and refers to the risk that is inherent in the entire market or economy. It cannot be eliminated through diversification and is caused by factors such as changes in interest rates, inflation, and political instability and so affects all securities in the market.
- Unsystematic riskis also known as specific risk and refers to the risk that is unique to a particular company or industry. It can be eliminated through diversification and is caused by factors such as management changes, labour strikes, and product recalls. Unsystematic risk can be diversified away by investing in a variety of companies and industries.
It’s essential to align your investment strategy with your individual risk tolerance, investment objectives, and financial goals, as diversification alone may not be sufficient to achieve your desired outcomes. Additionally, it’s crucial to consider relevant regulations and guidelines from bodies like the Financial Conduct Authority (FCA) to ensure compliance in your financial planning efforts.
When in doubt get professional advice. While diversification can be a powerful tool, it’s essential to work with qualified professionals who can guide you through the complexities of financial planning and ensure that your strategies align with your unique circumstances and goals.
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