One of the most common investment tips is to diversify your investments. The reason diversification is essential is to do with risk management. When diversifying your investments, you make sure they are not overexposed to risk.
However, investing in a range of funds doesn’t necessarily mean your investments aren’t overexposed. If you want to control your investment exposure, you have to look deeper into your investment portfolio.
What is Investment Exposure?
To understand overexposure, you should be aware of what financial exposure means. There are several distinct types of exposure in finance. Typically, experts refer to investment exposure as the amount of money you have invested in a particular asset. Investment exposure can further vary based on the method expression, the market you are exposed to, and what you stand to lose on an investment.
When you are determining your investment exposure, you need to look at:
- Your market exposure – how are your assets divided within an investment portfolio, as well within an asset class?
- Your financial exposure – how much money can you potentially lose on an investment?
If your investments are in stocks, it means your financial exposure to stock markets is 100%. However, your exposure within that asset class would be divided. You might have investments in gold stocks, technology stocks and so on, giving you a more limited market exposure within the asset class.
The key lesson to take away from investment exposure is that the higher your exposure to any particular asset type, the more overexposed you then tend to be.
How to Calculate Total Exposure?
An excellent way to understand your investment exposure is by calculating your total exposure. This can sound a bit daunting, but it shouldn’t. Calculating your investment exposure requires knowledge of your total investments and an understanding of how they are divided.
Likewise, if you are looking to start investing, you should calculate your exposure before you invest. Doing so will help you manage your exposure to any particular asset and market.
Here’s how you can calculate your total exposure:
- Calculate the value of all your investments.
- Identify how much you have invested in any particular asset.
- Examine the assets to understand their market exposure. For example, if you have different investment funds, what market exposure do those funds have, i.e. are they all investing in commodities and so on.
Let’s say that you have made £100k worth of investments. Now, a majority of these might be in your pension fund, but you could also have bought stocks and bonds. Your investment exposure could look like this:
- Pension fund – £50k total investment and 50% exposure
- Stocks - £30k total investment and 30% exposure
- Bonds - £20k total investment and 20% exposure
However, the above example might look different if your pension fund is directly related to stock performance, meaning your investment exposure to the stock market is 80%.
How Many Funds Should You Hold in a Portfolio?
As we can see, you shouldn’t keep all your eggs in one basket! Overexposing your investments to a particular asset type increases your risk – and all investments do carry risk.
Considering investment funds are a popular investment type, it’s a good idea to think about exposure when thinking about adding or keeping them in your overall portfolio. While you don’t want to overexpose yourself to a single fund, you should be aware of the risks of over-diversification. Because of market exposure, having many funds might not lead to lower investment exposure.
When you study where the funds are investing, you might notice that a lot of them are investing in a similar market. For example, you might have funds investing in European stocks which would mean your exposure to European markets is high. Likewise, your funds might be primarily focusing on commodities, leaving you overexposed to the whims of commodity markets.
Therefore, when picking investment funds, keep in mind what kind of market exposure each fund has and what this means to your overall investment exposure.
Diversification is the Best Way to Control Overexposure
If you are thinking about investing or you want to ensure your current investment portfolio is managing risks well, controlling exposure is crucial. The best way to do this is diversification of your investments.
If you only have investments in a single asset type, your exposure in this asset class is 100%, and your investments are overexposed. By having more than one type of asset in your portfolio, you are already limiting exposure and the risk of losing your investments.
As well as considering investment exposure in terms of asset types, you should consider exposure within each investment type. So if you are investing in the stock market, you want to limit your exposure to a particular stock type. If you have a sizeable property portfolio, you should consider limiting your exposure to one specific property type or market. For example, you would look at not only having properties in the same part of town or only renting out holiday homes.
Things to Consider when Controlling Your Investment Exposure
When you are looking at your investment exposure, here are the things you want to keep in mind:
- Calculate your investment exposure in terms of a particular asset class and ensure you’re not only investing in a single type of asset.
- Look at each asset class through diversification, limit exposure in terms of market exposure.
- Consider your risk appetite when deciding investment exposure. If you are okay with higher risk, then diversify accordingly and vice versa.
- Find a balance between overexposure and over-diversification. You shouldn’t add assets just for the sake of it or invest in too many fund types if you’re unable to follow up on those investments.
Controlling your investment exposure is an integral part of managing your portfolio. Whether you are just starting out or in the process of cleaning up your portfolio, it’s essential to understand your appetite for risk and your ultimate investment goals. This will allow you to know when your portfolio might be overexposed and help you make the correct choices.