Diversification is achieved by investing in a mixture of asset classes, countries, and investment styles. Essentially, constituents perform differently rather than moving mostly in tandem. But how does this work in practice?
How diversification works
Here’s an example to help. A shop selling ice creams can find business intermittent. When it’s hot, lots of people will want a cooling treat, but if it’s wet and miserable sales will probably be slow. But what if the shop started selling hot drinks too? It might not be able to stock as much ice cream and sell as many cones when the sun is shining, but sales of teas and coffees would help it keep going when the weather turns nasty.
That’s the principle of diversification, and it’s one of the most important concepts to grasp for investment success. Different investment areas tend to perform at different times, and no one area can be on top forever, which is why it’s important to hold a mixture. Diversification also protects you from poor results. If you hold too few or too similar investments, things can work well for a while but can also quickly go downhill.
How diversification reduces risk
There are some elements of risk you can’t avoid entirely through diversification. Most markets can move in tandem in the event of a market shock. However, diversification can help counter risks at a company, sector or country level. To take an extreme example, investing in the shares of just one company could put you in a vulnerable position if things turn sour for that business. It might feel safe to invest in a well-known company, but it is still just one business that can be affected by a myriad of factors and events.
By diversifying into several other businesses in the same sector you’ll spread the company risk but, importantly, not the risks affecting that sector. For instance, stocks in the energy sector will all be affected by the direction of energy prices, to some extent or another, and stocks in the housebuilding sector by house prices. By buying stocks in several different sectors you’ll be spreading those sector-specific risks too.
This is a decent start to diversification but it’s still reliant on shares. If something happened to affect the whole stock market then the benefits will be limited, albeit some areas tend to be more resilient than others during market falls. That’s why it’s important to hold other assets too, such as bonds, to smooth out the investment journey even more.
How to diversify your portfolio
A well-diversified portfolio is a simple concept but not necessarily an easy thing to achieve. It can take some consideration and depends on a number of factors – investment goals, timescale and the requirement for income. Here’s five tips to help your decision making.
1. Learn about funds
Most people don’t have the time or experience to pick individual shares, so if you are looking for a more convenient way to invest then funds are a great place to start. A fund pools together money from lots of investors and invests it a variety of shares or other assets.
Diversification can be time-consuming and expensive with individual shares, but with a fund a manager typically selects a range, usually 50 to 100, which means less reliance on the performance of any one company. The same applies to other asset types such as bonds too; risk can be partially mitigated by not having all your eggs in one basket. Follow the link for more on the benefits of investing with funds.
It's important to note that using a fund doesn’t automatically mean you are diversified. Some funds invest in specific markets or areas, while others contain more of a mixture. Some are more cautious, others more adventurous, so you should examine where a fund invests, it’s objectives and the risks involved before buying in. The documents about the fund, including the factsheet and the KID or (Key Investor Information Document) are designed to give you a good understanding. These can be found in the ‘Key Features and Documents’ tab on the fund’s page on the Charles Stanley Direct website or app.
2. Explore diversified funds
Choosing your own portfolio puts you in control, but with thousands of funds available it can be difficult for first-time investors to know where to start. However, there are some simple options worth considering to get going quickly and easily, and at low cost. One way of quickly and easily diversifying is to invest in a global passive fund or ‘tracker’.
These funds can be a good first option for those not able to spend time researching investments, providing straightforward access to many share markets around the world and therefore thousands of different companies. But remember the value of investments can fall as well as rise and with any investment you may get back less than invested.
If you want to be more hands on and tailor a portfolio using a combination of more specific funds, you’ll need a good mix. As well as thinking globally and investing across different regions, consider different types and styles of funds to make your investment ride smoother. As well as using other asset classes beyond shares, such as bonds, contrasting more defensive strategies with more adventurous ones can ensure a good spread of investments and that you are not overly reliant on certain areas.
For fund ideas for new investments for the longer term, more confident investors can take a look at our Preferred Funds. Selected by Charles Stanley’s Collectives Research Team, this highlights what we consider to be good-quality options in many of the major sectors and investment areas.
3. Decide on your investment approach
How investors divide their portfolios between different assets that might include shares, bonds, property and alternative investments is known as asset allocation. The proportion of different investment types held should reflect the amount of risk to be taken, the investment horizon and any other objectives such as the need for regular income.
A ‘balanced’ approach might be to consider 60% exposure to shares and 40% to bonds and other assets that could have the effect of dampening down the typically greater ups and downs of the stock market. The longer the time horizon for the intended investment the more an investor could consider allocating to equities. For instance, when investing for retirement multiple decades away an asset allocation that prioritises equities exclusively, or almost exclusively, could be considered.
When thinking about the composition the equity or share part of your portfolio you could consider the make-up of global markets as a starting point, illustrated by the geographical and sectoral composition of a global benchmark such as the MSCI World. However, this is dominated by the very large US market, and many investors choose to temper that a little as they don’t like to be too reliant on this area. Meanwhile, the UK is a small component of global markets, but some investors like to have greater exposure to more familiar London-listed companies.
4. Do research to find investments that match your goals
As investing maestro Peter Lynch advised, “Know what you own and why you own it”. Before investing in anything, whether it is an individual share or a broader fund, you should do your research:
- Check volatility
The make-up of your portfolio should be shaped by how much volatility (the extent of ups and downs) you are prepared to accept and your likely time horizon. Too little risk can be a wasted opportunity over the long term, while too much can put you in a vulnerable position.
- Avoid a ‘stamp collection’
Spanning different sectors and areas is important to spread the risk, but equally a portfolio shouldn’t become an unwieldy ‘stamp collection’ that becomes difficult to monitor and manage. Try to find a happy medium between variety and simplicity and avoid ‘diworsification’ where there are multiple holdings doing much the same thing.
- Don’t only pick winners
It may feel uncomfortable to invest in areas that are faring poorly, but investments often move in cycles, and when things turn around you could be in the right place at the right time. Remember too that recent winners taken from various sectors might give an illusion of diversification but tend to move in tandem with one another because they share a similar investing style.
5. Consider ready-made portfolios
The DIY investing route does mean dedicating a certain amount of time and effort into researching and monitoring investments, especially if you buy actively managed funds whose fund manager, style and relative performance could change over time. For some this research is enjoyable, for others a chore. If you don’t have the time or confidence to choose your investments, you could consider a ‘ready-made’ investment that provides a diversified portfolio in a single investment.
Our own multi asset funds, for instance, are monitored and rebalanced by Charles Stanley’s experts, each offering a diversified portfolio in one easy-to-buy investment while keeping to a chosen level of risk. Allocation between different areas is shaped by the economic views of the team, with portfolios reviewed on an ongoing basis with changes made when deemed necessary and to react to new opportunities. Multi asset funds also allow you to invest with small amounts that would otherwise mean diversification is difficult to achieve.
For those who want a straightforward, low cost and comprehensive product – and to avoid the work involved in putting together, monitoring and rebalancing a portfolio of different individual investments – these could be worth considering. Alternatively, they can help make up a ‘core’ of a portfolio around which other investments such as specialist funds or shares can be added to personalise it. One size cannot fit all, however, so it should never be assumed that any multi asset fund offers a perfect solution. The level of risk taken varies and you should be careful to select an appropriate one, or combination, for your needs.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.
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