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Why diversify? Reduce risk Predicting and timing the market is difficult, if not impossible and therefore sophisticated investors know that diversifying your investments is crucial. It reduces risk significantly without sacrificing much from returns. Risk can come in many forms; inflation, volatility, collapse in house market, currency movements, shift in interest rates which can impact different types of investments. Diversification is the first line of defence against these risks. Protect against uncertainty Nobody knows how our economy will perform in the future, what markets will deliver the best or worst returns, what inflation will do, or in what direction interest rates will move. The only way to protect against this uncertainty is to diversify across a range of assets, markets, sectors and securities. Diversification can be viewed as an insurance policy against uncertainty. Guard against inflation Many people shun diversification into shares and property altogether and prefer to keep all their savings in term deposits. This might feel safer, but inflation is the real enemy here which can decimate the spending power of your savings over time. Remove the need to time the market The price you pay for shares, property, bonds and currencies has a big impact on your future returns. However, trying to pick the best time to invest is very difficult because the future performance of markets is unpredictable. Therefore it is absolutely critical that investors not only diversify their investments but also diversify their market timing by purchasing their investments in instalments over a period of time. For more information on asset allocation and diversification please refer to Topic 9 of our ‘Overview of Investing’ booklet. Topic 4 – Why do share prices fluctuate? Share prices are determined by how well a company is performing. In general terms, if a company is growing its profits (and therefore dividends) this will likely result in an increase in the share price. However, it is important to remember that there is no automatic link between a company’s profit and its share price, as this is also determined by supply and demand in the market place. If investors get enthusiastic about a particular company and start purchasing their shares, this can push the share price up. Conversely if they become nervous about a company’s performance and sell their shares, the share price can drop. Ultimately the supply and demand of a company’s shares can be influenced by a number of factors: 1 1 The company’s current performance is crucial. If the company is making a profit and either pays out dividends or reinvests the dividends into the business (to enable capital growth), this offers value to the shareholders. Shareholders are less likely to sell and more investors are inclined to buy. 3 A range of economic factors affect share prices and 3 how they move including: a Economic growth – is the economy growing? b Overall consumer confidence and spending – if confidence and spending is high, companies are more likely to produce a profit c Unemployment – high unemployment has an impact on consumer spending d Inflation – if prices of goods and services increase due to inflation, this may suppress spending e Currency – an increase in the New Zealand dollar can benefit companies importing but would have a negative impact on profits of companies exporting f Market conditions – if some markets are volatile this can affect investor confidence and consumer spending g Interest rates – an increase in interest rates usually cause share prices to weaken 2 2 The company’s future performance will determine its future value. Any changes to the company’s future earnings (its ability produce a future profit to pay dividends and provide capital growth) will affect the share price, so if forecasts look positive this is likely to affect the share price positively. © Craigs Investment Partners 20125