Building an investment portfolio: why diversification is so important
Professional fund managers diversify their portfolios, seeking a balance between growth and risk by getting exposure to different asset classes, sectors and geographies. Individual investors should do the same, and it has never been cheaper to achieve diversification. Here’s why.
Diversification is about spreading investment risk
More than half of UK investors looking to buy shares over the next 12 months admitted to preferring well—known brands such as supermarkets and banks, according to a recent survey. But by opting for household names, investors risk overlooking a wealth of opportunities, putting all their eggs in a UK basket, and forgetting about the 'D—word'—diversification.
Diversification is a fundamental principle of investing, because picking one share is a high—risk strategy. It might look as though Apple or Amazon is a sure bet—but that’s what the employees and investors of Royal Bank of Scotland (RBS) and Lehman Brothers believed a decade ago.
They imagined that the familiar institution they worked for was as safe as houses, and they had a disproportionate investment in the shares of the banks. They learned the hard way that you have to spread risk.
Diversify your holdings of asset classes and diversify within them
The core way to spread risk is to own stocks, bonds and cash (considered to be securities or deposits maturing in one year or less). Adding bonds and cash to a stock—heavy portfolio lowers your overall risk. Reducing your bonds and cash in favour of stocks increases your total return potential. Most strategies play around with a mix of all three.
For example, a low—risk portfolio could be 20% shares and 80% bonds, a cautious one could be 40—60%, and an adventurous one could be 80—20%.
When it comes to stocks however, the choice is only just beginning, and can be overwhelming. Not everyone needs to own a Latin American trust, a micro—cap fund, or even a real estate investment.
Even if you are most comfortable investing with a UK theme, remember there are defensive or cyclical stocks which are dependent on the state of the economy, so—called growth or value styles of investing, hot or cold sectors such as oil or technology, funds skewed heavily towards dividends, and so on. The point is that all are liable to perform differently at different times.
That means you can (and should) diversify within your equity holdings.
Within bonds, you are offered a menu of government or corporate, high security or high—yield, UK or overseas. They too will be sensitive to external events, notably the prospects for inflation and interest rates at any given time.
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Diversification is about striking balance as well as finding winners
When professional fund managers share secrets of success, they will admit that the asset allocation to an investment area is the biggest factor in portfolio returns, and that a very small number of investments can often be responsible for a very large chunk of the returns.
The idea of asset allocation is to strike a balance, so you own different investments that do different things. Your aim is to minimise the risk you take for the rewards that you are targeting.
An analysis of 13 different types of investment over the past two decades shows that every year throws up a different winner.
Fidelity broke down financial markets between seven different equity sectors and three bond sectors, plus property, commodities and cash, then analysed which came out on top each year between 1997 and 2016.
In 2008, as the financial crisis struck, government bonds were by far the best performing asset class, while emerging market stocks were the worst. Yet just a year later, the roles were reversed.
Each new year sees pundits, analysts and fund managers give their predictions for what will be up or down in the 12 months ahead—and it’s telling how often so many of them are wrong.
The crash has also prompted investors to feel more vulnerable, to think more about diversification, and to look for other types of asset that appear to move in different ways, such as private equity and commodities. Those most concerned with income have turned to property and more recently infrastructure.
While property is a good diversifier, it can also create too rich a mix for some investors. Those who have become buy—to—let landlords, and who also own a high—value home will already be heavily exposed to property as an asset class without adding any real estate to their investment or retirement portfolio.
A well—balanced investment portfolio should give you peace of mind
Significantly, there is no year during the past two decades when all 13 investment areas went down at the same time.
In some years everything has risen together. This is why a well—balanced portfolio can help you sleep at night, because long—term investors can rely on diversification to deliver what it says on the tin.
And as legendary investor Warren Buffett has warned, a rising tide lifts all boats but ‘only when the tide goes out do you discover who's been swimming naked’.
It has never been as cheap to diversify
In the past, diversification meant either paying a fund manager to spread your invested money for you, or paying hefty dealing charges to buy a suitable portfolio of stocks. However, the advent of online trading platforms and exchange trade funds (ETFs) in particular, means diversification has never been as easy or as cost—effective.
Online trading platforms have reduced the costs of share dealing so it’s inexpensive and easier to diversify within a stock portfolio. ETFs mean it has never been as cheap and simple to diversify geographically both within sectors and between asset classes. You can buy ETFs that track the performance of whole equities indices, allow you to diversify based on income or growth or other investing strategies, or give you already diversified exposure to whole asset areas, for example.
And if you’re nervous about doing the diversification yourself, some investments providers do the work for you, offering diversified portfolios tailored to your own risk profile.
Learn more here.