Diversification – it takes more than a handful of stocks

Diversification is an essential tool we must use on our journey to investing success.

It’s used to help smooth out the ups and downs your portfolio could go through if you hold too few, or too similar investments.

By diversifying, you spread your money between different investment types to reduce some of the risks of investing.

Whether it’s types of companies, types of investments – like shares, bonds, and property – different parts of the world, or investment styles. There are lots of ways you can do it.

This article gives you information to help you build a diversified portfolio, but it isn’t personal advice. If you’re not sure of the best course of action for your circumstances get advice. Our advisory service could help.

Risks of investing

Risk is an essential part of investing. It’s unavoidable. The main risk you take when you invest is losing money. But you can also broadly split the risks you’ll come across when investing into two categories. Risks you can’t avoid, and risks you can help manage through diversification to avoid losing as much of your hard-earned cash if something goes wrong.

Risks you can’t avoid

These are risks you can’t get rid of, things like:

• Inflation rates – inflation erodes the value of money, so could eat into the value of future expected returns.
• Exchange rates – fluctuations in your local currency compared to the foreign-investment currency. It could erode returns from overseas investments.
• Interest rates – the potential that a change in overall interest rates will reduce the value of a bond or other fixed-rate investments.

Manageable risks through diversification

• Company – company risk is the financial uncertainty faced by an investor who holds securities in a specific firm.
• Industry – risk specific to a certain industry, that drags down the industry’s overall performance.
• Economy – changes to the conditions of an economy, like political instability, negatively impact a company or investment.

We’ve already learnt you need a team of players to be successful – no one player is more important than another.

It’s impossible to make the right decisions all the time. Even full-time stock pickers with decades of experience get it wrong. Some players just won’t perform as you expect.

Losing money in markets really hurts, but it can teach us valuable lessons if we’re willing to look through the short-term pain and refocus on the long term. Remember, investors who’ve been doing this a while have had their fair share of ups and downs.

One of the most successful investors of all time, Warren Buffett, once said “I make plenty of mistakes and I’ll make plenty more mistakes too.”

One company isn’t the answer – even the big ones

Sometimes we might feel more secure investing in a bigger, well-known company. In a lot of cases, they tend to rely, at least partly, on international business. So, when we think about diversifying across different geographies, we still need to do our research.

Let’s take companies listed on the FTSE 100 as an example – home to big names like Aviva, BP and HSBC.

Just because companies are listed on a UK stock market, doesn’t mean they’re only affected by what happens on our home soil. You need to think about where a company makes their profits too, to make sure you’re not too exposed to one area.

Lots of FTSE 100 companies carry out their business and sell their products outside of the UK. This means they’re recognised on a global stage, so are affected by currency movements, global policies and trends. This includes the US and Europe – the UK’s major trading partners.

We can compare this to companies listed on the FTSE 250, which is made up of the next 250 biggest UK companies after the FTSE 100. They’re usually more domestically focused, meaning they carry out more of their business in the UK than abroad. Acting as a good bellwether for the UK economy.

Although companies listed on the FTSE 100 might be more globally diverse, it doesn’t mean we should dismiss companies on the FTSE 250. A company listed on one of these indices isn’t better than a company listed on the other, they’re just different - which is great for diversification.

Why company size matters

How does diversification work?

The basic idea behind diversification is that your investments that perform well balance out, or outweigh, the performance of your investments that haven’t performed so well.

Assume you’d narrowed down your investment choices to five. You can’t be sure how they’re going to perform.

If you’d fully invested into investments 1 or 2, you’d have either lost or made no money.

Instead, if you spread your money between the five investments in a diversified portfolio, stocks 3, 4 and 5 could smooth out the ups and downs.

You never know, how they perform next year could tell a different story. You need to think long term when investing – that’s five years or longer.

The main objective to successful diversification is that your investments don’t move in the same directions – the less those investments have in common, the better.

What we mean by this is, imagine you’d invested all your money into a few energy stocks. Even though you’ve invested in several companies, we can assume that something that affects one energy company, will probably affect other energy companies too. This isn’t good news if there’s bad news.

Instead, if you’d purchased shares in an energy company, a healthcare company and a finance company, you’d have invested in companies with less in common. What affects one doesn’t necessarily affect the other.

Although this is a great way to start diversifying, they’re all shares. Any news that affects the stock market as a whole, could affect all of your shares to some level, no matter what industry.

That’s why it’s important to hold a variety of investment types too, like shares and bonds. Generally, stock markets and bond markets move in different directions. That’s why it’s good to hold a mix of both.

How can diversification help you reach your goals?

Picking individual companies isn’t always the answer, or the easiest way, to start diversifying.

Instead, you could think about investing in funds. A fund is a collection of investments chosen and run by a fund manager, where yours and other investors’ money is pooled together and spread across a wide range of underlying investments.

They’re managed and run by a professional, so you benefit from their expertise, knowledge and research.

If you bought shares in 50 or 100 different companies yourself, you’d see a big chunk of your money eaten up by dealing fees and other costs. In a fund, these costs are shared with other investors.

Whether you’re new to investing, or have been in the game a while, they’re a great foundation to any portfolio for instant diversification.

Each fund will have its own set of objectives, so you’ll need to make sure they align with your own as you start to build a diversified portfolio.

If you’re happy picking your own investments, next we’ll look at what you’ll need to think about as you start to research funds that could be right for you.

How can funds help me diversify?

If you don't have the time or confidence to choose your own investments, you could pay an expert to do it for you.

LEARN MORE ABOUT FINANCIAL ADVICE

Ready to start diversifying?

Our Investment Research team have put together some investment ideas to help you get started with diversifying a portfolio. They are not a personal recommendation to buy.

You could look for diversification with a fund that includes different investment types across lots of geographies.

Mixed investment funds can be a good way to start holding a variety of investment types too. They usually blend shares and bonds in different proportions.

Investing in funds isn’t right for everyone. You should only invest in funds if you have the time and know-how to diversify your portfolio to help reduce risk.

Before investing it’s important to check the fund’s objectives align with your own, understand the fund’s specific risks and if there’s a gap in your portfolio for that type of investment.

Remember, investments up and down in value, so you could get back less than you put in.

If you don't have the time or confidence to choose your own investments, you could pay an expert to do it for you.

Learn more about financial advice

Or read on to find out more about these funds, their risks and charges and their Key Investor Information Documents.