The dos and don’ts of diversification

We’ve already learnt picking one fund isn’t the be all and end all when it comes to diversifying your portfolio – you need to think strategically when you invest. If you have a portfolio full of funds, you might think diversification takes care of itself. That's not always the case.

This article gives you information to help you build and maintain 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.

Don’t just pick the winners

It’s easy to just select a handful of the best performing funds. It’s human nature to be drawn to winners and avoid the losers. But in investing, not much stays top or bottom of the performance tables for long. Today’s dog could be tomorrow’s chart-topper, and vice versa.

You need to build a team of players – remember, no one investment is more important than the other.

By investing in a wide variety, you’ll inevitably hold some investments that aren’t doing well at times. Although this might feel uncomfortable, you don’t want all your investments performing the same.

Funds with a narrow focus, like geographical or sector-specific funds, will usually see their values move as one in response to what’s going on in the market. With all the investments within the funds moving in the same direction at the same time, you could still see big movements in the overall value of your portfolio. Sometimes that might not be in the direction you hoped for. And only investing in what’s doing well at the moment could mean you miss out on some top picks for the future.

It’s important to think about this when building your portfolio.

More on building a portfolio

Do understand the underlying

Different areas and sectors will have different strengths and weaknesses.

We’ve already seen the US makes up more than 50% of global stock markets too. The S&P 500, which tracks the 500 largest US companies, makes up around 75% of the whole of the US market.

A large portion of the S&P 500 is made up of US tech companies too, being home to big household names like Apple, Amazon, Google-parent Alphabet, Netflix and Meta (Facebook). These alone make up nearly 16% of the S&P 500.

On the other side of the pond, the UK is quite different. It includes more of a weighting towards oil & gas and financial services companies.

Although some areas might seem more exciting, you need to look deeper into what you’re holding to make sure you’re not too exposed to the same things. For example, if you held a global fund, a fund that tracks the US stock market and also hold a fund that tracks Tech stocks, although you’ve spread your money further there could be more overlap than you think.

You can use the Portfolio Analysis tool in your account to check you’re not too exposed to one area. Tracker funds are a great way to diversify across the board and gain access to a variety of shares or bonds from different areas or sectors.

Managing your risk – two common investment mistakes to avoid

You don’t need everything to be successful

While diversification is an investing essential, we shouldn’t always take a ‘the more the merrier’ approach – you can have too much of a good thing.

There is such a thing as over-diversification. On one hand, diversification reduces the risk from holding too few investments. But on the other, if you hold too many investments, not only can it be hard to keep track of their performance, but if your funds have similar objectives, you could be holding a lot of the same thing.

The law of diminishing returns means that the second and third funds you add to your portfolio give much greater diversification benefits than the 20th.There’s no magic number for how many holdings you should have but it’s unlikely a portfolio with 20 or more funds is the best option. On the other hand, it’s difficult to imagine a truly diverse portfolio that has only one or two funds.

Costs

Costs don’t just include charges like trading commissions, there’s also the time involved. Most of us have jobs, families and other things to fill our time besides poring over company accounts. Keeping track of a large share portfolio, and hunting for ideas, can be a full-time job - this is where a fund manager could help. At a certain point, the diversification benefits just don’t justify all that extra effort.

But if you end up investing in numerous actively managed funds to diversify, you could just be creating an expensive tracker fund.

You’ll need to think back to your reasons for investing in the first place and see which funds match those objectives too.

Once you’ve decided on a mix of funds you think match your objective, compare their underlying holdings. If two or more funds have a lot of overlap, you could eliminate one of those funds from your list.

If two funds have similar underlying holdings, you could also go for the less expensive choice. Every penny you save on fees is one more penny spent working for you.

In our next article in the series we look at why successful diversification isn’t a one-time deal. Over time as markets move, your portfolio will change shape too. Sometimes these changes mean your portfolio no longer fits its original purpose.

Diversification – it’s all a balancing act

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 go up and down in value so you could get back less than you put in.