The importance of diversification in managing risk

There is little argument that the current economic environment has had a significant impact on the real value of our wealth.

In order for savings to grow, the rate of interest earned on savings must be greater than the rate of inflation. However, unearthing reasonable returns is challenging since very few savings accounts are close to meeting the current inflation rate of 2.4%

With no sign of the current situation abating anytime soon, investors and savers will need to hunt around to target better returns. If you are considering where to invest money and seeking out higher returns than available in FSCS protected savings accounts, then it is likely you will need to include some investments within your portfolio, which will involve some level of risk.  

The very nature of investing means that there will always be an element of risk to your capital. Whilst there is no magic formula to eliminate risk entirely, there are approaches you can take to help reduce the amount of risk your money is exposed to.

Saving and Investing - why diversify your portfolio?

Having a diversified portfolio is one of the key steps you can take to help reduce the impact of losses on your capital. Put simply, diversification is a way to spread your risk by investing your money into a variety of investment types with different levels of associated risks.

A mix of both savings and investments can be considered a sensible approach. Instead of putting all your eggs in one basket, it’s about finding the right balance of capital preservation and capital growth. Savings are more aligned to the preservation of capital and for the most part are protected by the FSCS (up to a maximum of £85,000 per institution) and include:

  • Instant Access Bank Accounts
  • Restricted Access Bank Accounts
  • Cash ISAs
  • Fixed Term Bonds*

*In some cases with Fixed Term Bonds your capital is at risk

Investing is focused on maximising growth with an acceptance that this will mean taking on an element of risk. You need to weigh up the risks and decide if the potential reward is worth any potential losses.  Different investments types include:

Direct lending as part of a balanced portfolio

In the same way we’ve discussed the importance of having an overall portfolio that is diversified across different savings and investment types, so too you can drill down further and diversify within different investment types – the more you diversify the better you spread out risk. Since. No single investment can be relied upon to produce safe, reliable and consistent returns.

Alternative investments such as Direct lending have become an increasingly popular option amongst investors in recent years. Direct Lending occupies the middle ground between the security of cash and the volatility of the stock market. Put simplistically, Direct Lending brings together investors and borrowers, typically through an online lending platform. 

If you are considering including direct lending within your portfolio, then diversifying your capital across different loans, loans types and lending platforms will help protect some of your money from downside risks should loans go bad and is an effective way to target good returns over the long term.

Spread your capital across number of loans

The more you can spread your capital across different borrowers the more you are able to shrink the amount of risk you are exposed to. It is difficult to predict the performance of any loan, no matter how well a lending platform has assessed the loan application. For example, if you lend to just one borrower and the loan goes bad, you could lose all your investment.

Spreading your money out across many loans could significantly reduce the amount of potential loss from loans that default. According to research from peer to peer lending analysis firm 4th Way, the odds of losing money in a recession can be up to 10 times higher when lending to just one borrower on a Direct Lending (P2P lending) platform. 4th Way applied international banking stress tests to several P2P platforms and found that when spreading capital across 100 loans, investors had just a 0.1% chance of losing 20% or more of their initial investment.

A direct lending portfolio that includes 100+ loans is more likely to better protect capital against losses. Types of loans should also be a consideration. Limiting the number of unsecured loans and focusing on asset backed lending can further reduce your exposure to risk.

Diversifying across different platforms

In addition to spreading your capital across different loans and loan types, you may also want to consider diversifying across a variety of lending partners. This will not only help you reduce the risk of bad debt but will also help protect some of your capital should a platform fold.

Of course, not all lending platforms operate in the same way or to the same standard, so it is important you do your research first. Look for platforms that have background in credit and investment. An experienced team will understand how to source and manage higher quality loans. You may find our article 'How do I choose a lending platform' helpful. Diversifying across different lending partners may also help to allocate your investment more efficiently. This is because different lending platforms have access to different loan opportunities.

Essentially with direct lending, spreading your money across several platforms, 100+ loans and varying loan types could significantly improve the amount of risk you are exposing your capital to.

Time constraints – managed, multi-platform auto-bid services.

Manually bidding is time-consuming and probably more suited to experienced investors who are used to managing their own direct lending portfolios.

For investors who are less experienced, or investors put off by the amount of time required to self-manage a fully diversified lending portfolio, then there are services that will help deploy capital across multiple lending platforms and loan opportunities. Auto-bid tools can help enable investors to diversify and spread their capital across 100+ loans to help minimise their exposure to risk – simply and quickly.

Any investment opportunity involves an element of risk. But if you are looking where to invest money in the current economic environment then a mixed portfolio of different investment types may help you tap into better returns.

As with all investments it is about carefully managing your risk and having a portfolio with the right balance of capital preservation and capital growth. Diversification is one of the key ways to help achieve such a balance.

*Warning: nothing in this article should be construed as advice. Your capital is at risk.

About BondMason

BondMason helps clients to access inflation-beating returns from fixed income and Direct Lending. Working with specialist lenders and approved partners, our clients can target a

gross return of up to 8% p.a.

Clients typically invest in 100+ different loan positions, creating a diversified portfolio in just a few clicks using the auto-bid tool.

Find out more:

BondMason Managing Risk 

How it works 

Helpful resources 

Download our free guide to Successful Investing in Direct Lending 

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