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There are lots of different strategies you can follow when it comes to a Stocks and Shares ISA. But there are a few rules that apply to everyone at every age and stage.
One of these is to think carefully about diversification – a key strategy for limiting risk. In general, it’s a good thing to aim for, but exactly what that means might vary from one person to another.
What’s the point of diversification?
The aim of diversification’s pretty straightforward. The idea is to limit the negative effect of any potential threat on the overall value of a portfolio.
That’s the basic idea, but threats come in different forms. An accounting issue – like the one WH Smith’s recovering from – matters a lot to the company in question but not really to any others.
By contrast, a rise in oil prices can be bad for airlines like easyJet for but good for the likes of BP. Or a political change might create a threat that’s specific to companies in one geographic region.
The point of diversification is to try and make sure that all of your investments aren’t exposed to the same risk. But not every investor should think about this in the same way.
Thinking about risks
Some investments are riskier than others – some companies face existential threats in ways that others don’t. And investors should factor this into their thinking about diversification.
With a stock like Unilever, for example, the risk of bankruptcy is pretty low. At any rate, it might well be lower than it is with a firm like Aston Martin Lagonda, which has gone bankrupt before.
This is worth keeping in mind. In terms of managing threats, something that has a much lower chance of going dramatically wrong can potentially be a larger part of a portfolio.
That means someone with a portfolio of riskier assets naturally needs more stocks than someone who owns shares in more stable businesses. And this is something investors often overlook.
One stock, several businesses
It’s also worth noting that some companies have more than one business. As an example, Judges Scientific (LSE:JDG) consists of around 25 subsidiaries that sell various scientific instruments.
That’s why I’m comfortable with it being one of my largest investments. The company has a degree of inbuilt diversification that limits the effect of challenges to any one of its businesses.
They are however, all located in the same industry. And that means lower research spending is a risk for the firm as a whole – and this is what’s been happening recently in the US.
The stock’s fallen as a result, but the company’s long-term strategy of acquiring businesses and improving them is one that I think has a lot of potential. As a result, it’s staying on my Buy list.
How diversified do you need to be?
There isn’t a single rule for diversification – the best way to approach the question is by thinking about what it’s supposed to be for. It’s about limiting the overall impact of any potential threat.
Investors don’t need to stay away from riskier stocks where the chance of bankruptcy is relatively high. But they do need to think carefully about the shares they own and plan accordingly.
