Why diversification is important when you’re investing

Cake choices diversify

Investing

Gareth Trainor

11th May 2017 at 6:00am

There’s lots of choice when it comes to investing: different industries, geographical locations and types of assets. But if you’re invested in only one or two of these then you could be exposing yourself to quite a lot of risk.

That’s why many people choose to invest in a way that spreads their money across a variety of investments to get the best balance between risk and return.

Let’s look at how you can invest in a way that will help you do this.

  1. Understand that investments behave differently to one another

Different investments are affected in different ways by factors such as economics, interest rates, politics, conflicts, even weather events.

What’s positive for one investment can be negative for another, and when one rises another may fall. We can’t predict all the factors affecting the performance of different investments, or asset classes, and in most years the difference between the best and worst performing asset classes is big – really big, as you can see in this chart.

Asset class performance chart

Past performance is not a reliable indicator of future performance.

Performance is based on the performance of relevant indices* and is calculated using Financial Express (FE), as at 28 March 2017. In pounds sterling, gross income reinvested, bid to bid. Calendar year performance is from 31 December to 31 December.

Please note that the numbers quoted don’t include the charges you’d have to pay if you invested in these asset classes through a fund. 

  1. Check where you’re invested

If you already have some investments, for example through a stocks and shares ISA or your pension, when was the last time you checked where you’re invested? If you’re invested in too few investment types, you could be unnecessarily exposing yourself to risk.

When you check, don’t be lured into positive short-term returns of individual asset classes and regions. Always remember that generally, investing is for the long term and that you need to look at the overall performance of all your investments.

The table above illustrates why only considering short-term performance can go wrong, and why you should be diversified. The best-performing asset class tends to change year on year, and the performance of some asset classes can vary substantially from year to year.

  1. Decide if you want to DIY or delegate 

Do it yourself

Professional investors, such as fund managers, use sophisticated models and many years of experience to determine what to include in portfolios, and in what proportions.

It’s a lot harder for amateur investors; given the interconnected nature of all the potential investments in the world, diversifying can be difficult to get right.

But if you’re an experienced investor, you might want to do it yourself. If you do, the best approach is often not to think about investments’ individual characteristics, but the impact they have on your overall portfolio.

To get the real benefit of diversification – the average return of your investments, but less than average risk – think about choosing investments that don’t move in the same way as each other.

How investments move in relation to each other is called correlation. If two investments are negatively correlated, that means generally when one performs well, the other won’t. If two investments are positively correlated, they’ll generally both perform well at the same time.

Or delegate by choosing one of the many ready-made options

Even if you have the time and expertise to manage your investments, it’s difficult to build a truly diversified portfolio without the tools and knowledge available to professional investors. That’s why many people instead decide to pick a ready-made diversified fund.

There’s now a lot of choice and many investment companies have teams dedicated to building and managing diversification strategies. You can even choose funds that not only diversify the traditional investments and regions, but also specific investment strategies. So if you don’t want to tackle it yourself, there are plenty of ready-made diversified options that aim to give you the highest possible return for a given level of risk.

  1. Remember to regularly review

Whether you do it yourself or opt for a ready-made option, it’s important to keep an eye on your investments to make sure they remain on track to meet your goals.

Most people review their investments by looking at performance – which can be useful – especially if you compare this against the investments’ aims and how other similar things have done.

What most people forget to do is look at all their investments as a whole. For instance, if you look at any ISAs, pensions or shares you have, do you know how much you have in each asset type or region? You don’t need to be a rocket scientist to do this, and it doesn’t need fancy tools or websites.

I use a table like the one below, and roughly list how much money I have invested in each box. That usually highlights any obvious issues. I then look at my options and decide if I need to take any action.

Asset class allocation table

*Indices:

  • Cash – LIBOR GBP 1 Month
  • UK government bonds – FTSE Actuaries UK Conventional Gilts All Stocks Index
  • Corporate bonds – IBOXX UK Sterling Corporate All Maturities Index
  • High yield bonds – Bank of America Merrill Lynch Euro High Yield Index
  • UK commercial property – IPD UK All Property Index
  • UK equities – FTSE All Share Index
  • Europe ex UK equities – MSCI Europe ex UK Index
  • US equities – S&P 500 Index
  • Japanese equities – TSE TOPIX Index
  • Asia Pacific ex Japan equities – MSCI AC Asia Pacific ex Japan Index
  • Emerging market equities – MSCI Emerging Markets Index

This blog and any responses to comments should not be regarded as financial advice.

Stocks and shares ISAs and pensions are investments. The value of investments can go up or down, and may be worth less than was paid in. Past performance is not a reliable indicator of future performance. Information correct as at May 2017.