Join our community of smart investors

Dos and don'ts of diversification

Diversifying your portfolio across different assets can help to mitigate downside
Dos and don'ts of diversification

If you’ve built up a decent amount of wealth you’ll want to at least preserve what you’ve made or maybe continue to grow it. And one of the main ways to do this is to diversify your assets.

By ensuring your portfolio is well diversified across different asset classes, geographies, styles and size, you spread your risk exposure. If something goes wrong with one security, because it only accounts for a small proportion of your investments, it won’t be too detrimental to your overall wealth. Meanwhile other uncorrelated assets might be doing well, or at least not falling as badly. 

Funds are a good way to achieve a diversified portfolio because each one is a basket of securities and just one of these gives exposure to tens or hundreds of securities. 

As a private investor some assets are out of reach to you, including pretty much all of the bonds in issue globally, commercial property, infrastructure and private equity. But you can access them via funds.

You also need to diversify within your equity exposure. UK private investors cannot buy all foreign-listed shares directly, in particular in important growth areas such as emerging markets. And even where it is possible to buy shares listed overseas – for example, some of those in the US or continental Europe – there can be adverse tax implications and brokers tend to charge more to trade them. 

Some key sectors such as information technology, meanwhile, are under-represented in the UK market, which is heavily skewed to areas such as oil and mining.

There are two approaches you can take to diversifying your wealth: selecting a range of funds that cover different assets and geographies, or investing in a multi-asset fund that via one holding gives you exposure to a wide selection of assets. If you want to go for the latter option, see Make the most of the many uses of multi-asset.

 

Setting the right asset allocation

Whichever approach you take, it is important that you set the right asset allocation for your financial goals and personal specifications. 

To determine what the right balance of risk and return is for you depends on a number of factors. These include your investment time horizon and what you are going to use the money for. If you want to grow the money you will need to take on some risk, or if you are looking to preserve it you will need to limit risk. 

Your asset allocation also comes down to personal preferences and tolerances: even if you have a long enough time horizon for any market corrections to recover, could you tolerate the value of your investments going up and down? If you’re investing for five to 10 years, you should be able to take a multi-asset approach, and this could help your portfolio avoid the most extreme moves in markets. If your time horizon is 10 years or more and you want your assets to grow, then it makes sense to be heavily invested in equities, maybe as much as 80 per cent of your investments. But this should still be well diversified in terms of geography and sector

 

Global equities funds

You could invest the part of your portfolio that you have decided to hold in equities in a range of regional and sector funds. But if you are unsure of how to asset allocate between different geographies and sectors, or don’t have enough time to do the extensive research necessary to determine the correct split and find good funds with which to express it, you could hold a global equities fund alongside funds that invest in other assets.

If you opt for this approach it is very important to scrutinise the make up of global equities funds because they vary considerably.

Passive funds follow a broad global index, so make sure you know which one it is, what its allocations are and if they are suitable for you. Passive global fund options include HSBC MSCI World UCITS ETF (HMWO), which tracks MSCI World index and has a low ongoing charge of 0.15 per cent. Legal & General International Index Trust (GB00BG0QP604), meanwhile, tracks FTSE World (ex UK) Index and has an even lower ongoing charge of 0.08 per cent. Our table below shows their geographical breakdowns.

 

 

Global equity indices also rebalance regularly, so make sure you check a passive fund's asset allocation at least once a year and are satisfied that it continues to meet your requirements. For example, MSCI World index is heavily weighted to developed markets, so does it have a strong enough growth profile for you? Or do you need more emerging markets exposure? If the latter, you need to hold a global emerging markets fund alongside your global equities fund to ensure that you achieve the equity allocation you decided is appropriate for you. Not having the right exposure might mean that you do not meet your growth targets. 

Global emerging markets fund options include Fidelity Emerging Markets (GB00B9SMK778) and JPMorgan Emerging Markets Investment Trust (JMG).

MSCI World index’s developed markets exposure is highly focused on the US, with a weighting of 63 per cent at the end of November. If you hold a fund tracking this index you need to consider if you want that much of your equity exposure in this market, which hit new highs last year. US equities also don’t have as much potential for growth over the long term as Asian and emerging markets.

Active global equities funds need even more due diligence and monitoring because their allocations can vary considerably to each other, and they can change frequently. But they may have a better geographic balance and, even when they are invested in arguably expensive markets such as the US, may not be as heavily weighted to or holding more highly-valued stocks.

Active global equities funds may also have a higher allocation to Asian and emerging markets, and cheaper developed markets. But you need to check exactly what is for each one and monitor the one you hold regularly.

Also consider whether an active global equities fund’s exposure fits in with your requirements, for example, would a significant allocation to emerging markets and Asia be too high risk for you?

Active global equities funds include Rathbone Global Opportunities (GB00BH0P2M97) of which the positioning is largely determined by where lead manager James Thomson believes the best investment opportunities are, but he avoids direct holdings in emerging markets. So the fund has very little exposure to Asia and emerging markets meaning that if you need exposure to these areas you need to hold further funds alongside it.

If you want to tailor the geographic allocation of the equity segment of your portfolio more specifically you can invest in a selection of regional equity funds. 

You can see more suggestions on global equities and various other kinds of funds in the IC Top 100 Funds, IC Top 50 ETFs and our weekly fund tips.

 

Other assets

The percentage of your portfolio that you allocate to non-equity investments could be spread across bonds, and real assets such as infrastructure, commodities and commercial property. Also don’t forget cash – especially if you are looking to preserve wealth.

But don’t be too cautious in the early stages of your investment timeframe if you want the money to grow, for example, don’t have a high allocation to cash if you have five or more years to invest.

What you pick and in what proportions depends on the asset allocation that you have determined. Make sure you pick assets appropriate for your purposes. For example, if you are an income investor property, bond and infrastructure funds might be of greater interest, while gold might suit a wealth preservation goal. Growth investors with a high risk appetite, very long-term investment horizon and large amount of assets could consider a small allocation to private equity investment trusts.

 

Diversification don’ts

When you putting together the asset allocation you have chosen, make sure that your various investments do different things to each other. Some assets can have reasonably high correlations to ones that seem very different. 

"For instance, investing in mining funds and Latin American equities may offer little diversification," says Rob Morgan, pensions and investments analyst at broker Charles Stanley. "Both tend to be reliant on the commodities cycle, so it may mean the two areas rise and fall at the same time."

Technology-related companies, meanwhile, account for a substantial proportion of the US stock market. "If you invest in a US equity fund and a technology fund you risk being overexposed to the technology sector, which would be bad news when it falls out of favour," explains Patrick Connolly, chartered financial planner at Chase de Vere

If you have any direct shareholdings make sure that the UK funds you hold don’t have large stakes in them or you will end up over exposed to individual securities.

It is also very important not to over diversify. Too many holdings dilute the effect any one investment can have on your overall returns – even if its performance is great. And the more holdings you have, the greater the costs you rack up – both in terms of annual fees and the charges you pay to trade the investments. Around 15 funds should be enough to diversify larger portfolios, and smaller ones should look to hold fewer.

For many investors, one fund focused on each region, sector or non-equity asset should be enough. But if you have a larger-sized portfolio and have more than one fund focused on an area, ensure that they don’t overlap with each other in terms of style or holdings. There is no point having several funds doing largely the same thing.

Hold funds that complement each other. So, for example, one Europe large-cap equities fund and one Europe smaller companies fund.

If some of your investments perform well and others perform badly, this can significantly alter the asset allocation and risk profile of your portfolio. So review your investments reasonably regularly – maybe one to four times a year – and rebalance to ensure that the asset allocation continues to meet your objectives and attitude to risk. The aim is to take your portfolio’s asset allocation back to where it was when you started out.

"Rebalancing involves selling some of your investments that have performed well and now represent a larger proportion of your portfolio and reinvesting in those that have performed poorly and are now a smaller amount of your portfolio," explains Mr Connolly. "Rebalancing ensures that you don’t take too much risk and, by selling investments that have done well in favour of those that have done badly, you are effectively selling at the top of the market and buying at the bottom. Investments that have performed well usually become more popular as investors believe that strong performance will continue."

This means that such securities may be more expensive. So when choosing investments also don't base your decision purely on what has done well over the past five years, adds Petronella West, chief executive officer of wealth manager Investment Quorum. These won't necessarily be the best performers over the next five years. 

You also need to change your asset allocation as your needs change over time. For example, don’t have too much risk as you approach the time when you need to start drawing on the assets.

Trading frequently will also rack up trading costs that will eat into even more of your returns. If you have a long-term investment horizon there is no reason to constantly trade: markets may go down but you can wait till they go back up and recover your losses.