It has been called the investors’ secret weapon: the means to share in the gains that the stock market can offer over the long term while shielding yourself from the worst of the falls that are part and parcel of owning shares. It goes by the “official” term of diversification or by the more homely one of not putting all your eggs in one basket. How can it be achieved in practice?
What does it mean?
Let’s think about the FTSE 100 index, which consists of the 100 most valuable companies on the London stock market. Imagine you choose one company in this index and decide to invest all your money in its shares. There is a risk – small, but not negligible – that this company will go bust and you will lose all your money.
Now imagine that you split your money into 100 equal parts and spread it among all 100 of those companies. There is, short of Armageddon, no chance that all 100 will go bankrupt. By hedging your bets in this way, you protect yourself from the worst possible outcome: total loss of your money. If you own 100 stocks, some will do well and others not, but overall you stand a very good chance, if history is any guide, of growing your money over time.
Diversification is enhanced further if you invest in smaller stocks than those in the FTSE 100, and therefore spread your investments more widely across sectors, and also by investing internationally.
Diversification does not mean just buying a variety of stocks instead of only one; to achieve diversification involves owning more than one type of investment. A truly diversified portfolio may include stocks, bonds (which pay a fixed return each year), property, perhaps some gold, other commodities and possibly even more alternative assets. The idea behind this is that these investments tend to rise and fall at different times; often bonds go up when shares go down and overall performance is therefore smoothed out.
How to diversify a portfolio
Everyone should have a diversified portfolio – remember the example of owning the one FTSE 100 stock – but the type of diversification you need depends on your age, your investment goals and your attitude to risk.
An investor in his or her 20s, for example, may want to forget about bonds, property, gold and so on and just put everything in the stock market, as long as the money will not be required for a very long time, such as at retirement. Although over the ensuing decades there are bound to be many ups and downs, the long-term record of stock markets suggests the saver will have made handsome returns at the end. But, as we have said, that twentysomething saver must diversify his or her stock market holdings to avoid the risk that the failure of one business severely reduces the value of their investments.
As you get older, or closer to the time when you need to draw on your savings, a more diversified portfolio in the sense of owning a greater variety of asset types becomes appropriate. In one’s 50s and 60s, it makes sense to start adding some bonds and property because, in the event of a severe stock market fall, the time available for it to recover is steadily dwindling.
If you are very risk averse – find out by asking yourself how you would react to a fall of 30% or 40% in the value of your portfolio – it would be best to increase your level of diversification sooner.
If you do decide to choose your own stocks, you could find yourself with a poorly diversified portfolio even if you owned shares in, say, 20 companies. If, for instance, you owned shares in 20 firms focused on artificial intelligence (AI), you would be very exposed to the risk of a reversal of sentiment towards it or a failure of the technology to live up to expectations. So it is best to be diversified across industry sectors and types of businesses.
It is easy to see the advantages of diversification but are there any disadvantages? One is the danger of “over-diversification”. This refers to the fact that the returns from a basket of shares or other assets are increasingly likely to converge with the return of the market as a whole as you own more and more holdings. Very diversified portfolios can also become cumbersome to manage so a happy medium is called for.
If you seek to achieve diversification through owning a portfolio of funds, it is important to spread your savings across investment styles, including growth and value. If one style is out of favour, then the other investment styles should be able to offset this. Multi-asset funds can be used for you to achieve true diversification according to your own risk profile.
