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What exactly is diversification?
Before we look at how to diversify your investment portfolio lets discuss what exactly diversification is. Diversification is a simple concept. Don’t put all your eggs in one basket, right? Truth is, if that’s your approach to investing then you’re definitely on the right track but there’s more to it than you might realise.
The behaviour of these assets in relation to each other is just as important as well the percentage of your money allocated to each individual asset (weighting). A properly diversified investment portfolio can help to maintain a respectable return come rain or shine, whilst managing your overall risk.
Diversification by asset class
If you’ve read our beginners guide to investing, you’ll now know that there are a number of different assets available to you as an investor and that each asset type carries its own level of risk.
During the financial crisis of 2008, share prices fell dramatically. If your portfolio consisted of mainly equities, then this would have been a very painful year. By contrast, during this period, gold and oil prices soared. This is no coincidence. The correct term for this is that these assets are negatively correlated.
In other words, property, gold, and assets such as bonds tend do well when equities fall. This is partly because they are seen as a safe haven by investors during times of uncertainty. In short owning a range of asset types prevents over exposure to a single risk and enables you to profit from growth regardless of where that growth lies.
Geographical Diversification
Given that the world economy is continually growing, it makes sense to invest globally. When one part of the world such as the UK or Europe isn’t doing so well you might benefit from those regions that are doing much better.
It might also pay to have a small amount of your portfolio invested in emerging markets for example, where growth can be rapid in comparison to other regions. It is easier than ever to have exposure to such markets through geographically focussed funds and index trackers such as the Legal & General US Index fund.
Company Size and Sector
Investing in larger, well-established companies such as Shell or BP can give a degree of certainty in terms of risk. The downside is that they are unlikely to experience significant further growth.
Smaller companies have the potential to grow more quickly but carry inherent risk due to their inability to weather any potential storm. For this reason consideration must also be given to the company size when planning your investments.
As with the above, diversifying across a number of sectors can also be beneficial in ensuring you benefit from growth. A recent example is the effect of the Covid-19 pandemic on certain sectors.
The increase in people working from home meant that Technology companies such a Zoom Video Communications Inc experienced significant growth whilst Retail and Aviation sectors suffered huge losses.
Finding a Balance
Taking all of the above into account can seem a little daunting but for most the answer will be to invest in small number of carefully chosen and researched funds that give you good exposure to a number of well diversified assets.
As few as four or five funds may be sufficient to give a decent level of diversification across the board. The other obvious benefit is that this method keeps your fees to a minimum.
A simple spreadsheet can be used to collate the information gathered for each individual fund. More experienced spreadsheet users may be able to create graphs and pie charts to give a visual indication of diversity.
The information for each fund is usually fairly easy to find with a quick internet search. In addition sites like Hargreaves Lansdown and Morningstar provide reviews, comparisons, and ratings as well as insights into each particular fund manager and their team. These can be invaluable resources for those starting out.
Given that each person’s needs differ greatly, whether you opt for a more conservative or adventurous portfolio is your choice. As always do your research and ensure you’re fully aware of exactly where your money is invested. Check out our good reads page for some great books and resources.
Rebalancing your Portfolio
If you have successfully diversified it stands to reason that one sector or asset may do better than others in any given year (that’s the whole point, right?). Over time this can lead to a deviation away from your intended weightings and asset allocation which could affect the overall performance of your investment long term. For this reason you must periodically redress the balance.
Rebalancing is to take some of your money out of your best performing assets and place it with those which haven’t fared so well. For many investors this can seem a little counter intuitive, however it is important for long term performance and managing your investment risk.
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