When it comes to investing, a common maxim heard by many investors is ‘don’t put all your eggs in one basket’. This simply means when deciding where to invest, it’s worth putting your money across a range of different investment vehicles or sectors, rather than betting on just one company – this is known as diversification. In this article we look at what diversification is in more detail, what it means for your investment portfolio, how you achieve a diversified portfolio and what you need to consider to make the most of your investments over the long term.
What is diversification?
Diversification is a commonly thrown around term in the investment world but what does it actually mean? Simply, diversification means having a variety of different investments in your portfolio – this might include a mix of investment vehicles and asset types, such as bonds or equities, or investment trusts, commodities or real estate.
An investment strategy or process which follows this maxim is often called a diversification strategy. The reason for adopting diversification as an approach when investing is because spreading the investment helps to reduce risk for investors, rather than relying on an individual stock to outperform. It should hopefully result in more consistent returns over the long term too.
Understanding the basics of diversification in investing
Thinking about diversification in investment simply means having a range of investments in your portfolio. You can do this in a number of ways:
- Ensure you have a mix of asset classes, such as equities, bonds, investment trusts, real estate, commodities.
- You can also diversify by choosing investments from different sectors and industries, or by geographical location, or by size of business even.
- You can invest in a range of individual funds which have a single strategy approach – this means they focus on a specific asset class, region or sector, or choose to invest in a diversified fund that effectively does the work of selecting a range of investments for you.
- Diversify by the length of time you invest. For example, you may invest in a bond that matures in five years if you are looking for a quick return, or for 25 years if you are happier with a longer period of time.
The benefits of diversification are that you are spreading the risk across a range of investments, therefore if one or more investments has a period of underperformance, it may be offset by better performing investments in your diversified portfolio. This should also help to achieve more consistent investment returns over the long term.
However, it is also worth being aware of the potential pitfalls of over-diversification. If you are selecting individual funds then each is likely to have management charges – the more you select, the more expensive it may be, which could hurt the performance of your portfolio over time.
Types of diversification
As looked at briefly above, there are different types of diversification, which are set out in more detail below.
Diversification by asset class
Diversification by asset class is when you look to have a mix of different investment types in your portfolio. This mix may include shares in companies, money in bonds, and/or investments in real estate or commodities, investment trusts or even cryptocurrency. Each asset class will have a different overall typical level of risk but the risk profile of investments within those asset classes will also vary.
For example, as an asset class equities (shares) are generally viewed as a lower-risk asset class than cryptocurrency, yet higher risk than bonds. Yet the risk rating of individual assets in a class will vary, sometimes widely. As an example, many government-issued bonds, such as US government bonds, will have a low perceived level of risk due to the stability of the US economy. In contrast, a corporate bond issued by a small firm operating in a niche sector may be viewed as far riskier.
Foreign diversification
You can diversify your investment portfolio by widening your geographical approach. This could mean having holdings in developed markets such as the UK stock market or one or more European stock market indices, as well as holdings in emerging markets such as India, Brazil or China.
One advantage of investing across a range of geographical locations is that what is happening in one economy is not likely to be mirrored by another economy several thousand miles away across the globe. Therefore, you are spreading your risk and opening up new opportunities at the same time.
What are the advantages of diversification?
There are many advantages of diversification. As explained above, having a diversified portfolio broadens your exposure to different markets or sectors and therefore reduces the risk of holding all your eggs in one basket.
While a single market or sector will either do well or badly at any one time, having a diversified investment portfolio will help to reduce volatility and the fluctuations in value that you are likely to otherwise see. Effectively, investors could achieve a greater return on their investment for the same level of risk compared with an undiversified portfolio.
If there is a market crash, then many people look to withdraw assets from the stock market. However, if your portfolio is diversified then the withdrawals you look to make may well be lower, as not all areas or stocks or markets will necessarily be affected.
Something less talked about but equally valuable to consider is the relative lack of stress from opting for a diversified portfolio as opposed to an undiversified portfolio. With the latter you are constantly having to try and pick the winner, as otherwise you will lose out. If you build a diversified portfolio then you there is less pressure to ‘pick a winner’ as a balanced approach should, by definition, include a range of funds and therefore less reliance on a single fund.
Are there any disadvantages of diversification?
There are potentially disadvantages of diversification. In theory, the more investment decisions you make, the more mistakes you can potentially make – in other words, you have broader exposure to different risks. However, as shown above, this disadvantage is likely to be outweighed by the benefits of choosing different assets.
It is also important to be aware that different asset classes have individual investment characteristics. For example, they will have varied levels of risk and the conditions under which they are likely to perform well and badly will also vary. The more asset classes you choose to invest in, the more time you need to spend to ensure you fully understand what you are investing in.
Diversification can also be more expensive than investing in a single fund as you will be paying more investment charges. Investing in a fund that is multi-asset may also incur higher charges, as you are paying a management fee to the multi-manager but also to the managers of the underlying funds. However, if well managed then a multi-asset fund should provide consistent returns which should help to outweigh these.
How to diversify your portfolio
Diversifying your portfolio involves making sure you have a range of investments across different asset types, geographical areas, sectors and even company size – small cap, mid cap and large cap stocks for example. This could include some exposure to emerging markets as well as developed markets or investing in the energy sector as well as the pharmaceutical sector.
It is important to have a diversified portfolio to reduce volatility in particular, as asset classes will perform in different ways according to what is happening in the markets. However, when it comes to determining the mix of investments, this should be based on your attitude to risk, your investment goals and the time horizon in which you plan to stay invested.
In order to achieve good returns, it is normally necessary to hold a decent amount of stocks – while these are higher risk than some investment classes, they are also typically higher return. Investors may also want to include bonds, unit trusts or even real assets in their portfolio.
It is also worth diversifying across time, with different investments held or due to mature at different times. This means that you are not relying on many different investments to be performing at the same time. Furthermore, as you approach retirement it may be wise to reduce your allocation of shares in favour of a higher proportion of lower-risk investments such as bonds or cash holdings.
Building a diversified portfolio
Liontrust has a range of funds that may be worth exploring that offer investors the chance to build on diversification strategies. These include the Multi-Asset funds which include a range of options to suit different investors’ needs. The Sustainable managed funds also include a range of options aimed at meeting different investors’ needs.
