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  • The dos and don’ts of diversification

    Although diversification is an essential tool for a successful portfolio, there are still some dos and don’ts you’ll need to think about.

    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

    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 with your core-satellite strategy in mind. The core should be a mix of funds that act as the foundation to your portfolio. They might not be the most exciting of performers, but they’re there to help keep things steady.

    The satellites come in for an added pop of diversification, and to help you put your own personal spin on your portfolio. They could be funds that offer something different to make your portfolio more well-rounded. You can use them to invest in different areas and stock markets around the world.

    Holding a mix of satellites to support your core should mean you’ve always got some investments working in your favour.

    Do understand the underlying

    Different areas and sectors will have different strengths and weaknesses.

    We’ve already seen the US makes up nearly 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 Amazon, Google-parent Alphabet and Facebook. These names alone make up more than 20% of the S&P 500.

    On the other side of the pond, the UK is quite different. It includes more 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 risks of holding too few investments. But on the other, if you hold too many investments it can reduce your returns.

    The law of diminishing returns

    The law of diminishing returns means that the second and third shares you add to your portfolio give much greater diversification benefits than the 100th share.

    The graph below shows the theoretical amount of share specific risk (not market risk) that’s eliminated by portfolios of different sizes. Remember, it’s only the share specific risk that can be reduced through diversification. The market risk is always there regardless of how many companies you own.

    Chart showing the diminishing returns of diversification

    Source: Tang, 'How efficient is naive portfolio diversification?' 2004.

    There’s no magic number for how many holdings you should have but it’s unlikely a portfolio with more than 20 funds is the best option. On the other hand, it’s difficult to build a truly diverse portfolio without holding at least 10 investments.

    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.

    Investment ideas

    Legal & General International Index

    • Invests in thousands of companies around the world.
    • Gives access to sectors like technology, financials and healthcare.
    • One of the simplest ways to invest.

    Find out more

    Find out more

    Troy Trojan

    • Made up of a mixture of different investment types.
    • Investments from around the world.
    • Could bring some stability to a more adventurous portfolio.

    Find out more

    Find out more

    Legal & General International Index

    A global tracker fund could offer instant diversification to a long-term investment portfolio.

    Tracker, or index, funds try to track the performance of an index, instead of trying to beat it.

    The Legal & General International Index aims to track the performance of the FTSE World ex UK Index. It’s made up of markets like the US, Japan and Europe, but also includes some higher-risk emerging markets like Korea and Taiwan. The fund can also invest in derivatives, which can increase risk. Because of the size and strength of the US stock market at the moment, American companies make up almost two-thirds of the fund.

    The fund invests in around 2,200 companies, across sectors like technology, financials and healthcare. It mainly focuses on some of the world’s biggest and most established businesses.

    The fund is managed by Legal & General, one of the largest providers of tracker funds, with plenty of resource and expertise to try to track the market as closely as possible.

    An index tracker fund is one of the simplest ways to invest. This fund could be a good addition to a broader investment portfolio aiming to deliver long-term growth.

    More about this fund, including charges and how to deal

    Legal & General International Index Key Investor Information

    Troy Trojan

    Investing in a number of different companies isn’t the only way to diversify a portfolio. Different investment types could help too.

    Total return funds could be a good choice as a balanced option because they’re more conservative. They normally hold a mix of shares, bonds, commodities and currencies. This could offer modest growth over the long term and help shelter money when stock markets fall. But they aren’t likely to keep up with stock markets when they rise quickly.

    Troy Trojan is run by experienced fund manager Sebastian Lyon. Part of the fund invests in shares of well-established companies in countries like the US and UK and some smaller companies too, which can be more volatile. The rest invests in UK government bonds and US inflation-linked bonds, which could provide some shelter from rising inflation. It also holds gold and cash, which can help offer some stability when times are tough in the economy and stock markets.

    Overall the fund holds a small number of investments. This means each one can have a meaningful impact on the performance, but it does add risk.

    The fund could form part of the foundation of a broad investment portfolio, bring some stability to a more adventurous portfolio, or provide some long-term growth potential to a more conservative portfolio.

    More about this fund, including charges and how to deal

    Troy Trojan Key Investor Information

    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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