Using diversification to defend your investments

Being a successful investor is dependent on a combination of factors - there’s no single winning formula.

Yet experts are unanimous that an essential element of any portfolio is diversification.

By owning a variety of asset classes, each of which behaves differently during the market ups and downs, it’s possible to create a portfolio which can handle any inevitable market downturns - by minimising risk and smoothing out returns.

The Brexit vote reinforces the need for investors to diversify their portfolios - as well as to take a long-term approach to saving.

The benefit of mixing up the asset classes

Hannah Edwards, financial planning director at BRI Wealth Management, says: “Diversification is crucial whatever your circumstances or attitude to risk, to protect your savings from market shocks."

Good diversification has been proven to help investors avoid the worst of financial market ups and downs

“Investors need to have a basket of assets which are as uncorrelated as possible so that if one asset class does badly then the others that are doing well balance it out."

To make sure a portfolio is spread across asset classes, it could contain a blend of equities, bonds, cash, and alternative asset classes such as property to benefit from their different investment cycles.

Diversification includes investing in various geographic locations as well as in different asset classes. World stock markets do not all perform in the same way at the same time, which means this is another solid way to spread risk.

As well as funds which invest in companies listed in the UK, there are global funds to choose from that invest in companies listed on overseas markets.

Investing far and wide provides more opportunity for diversification and offers access to countries where economic and profit growth may be much higher than in Britain.

Add depth when diversifying

Investors should also consider diversifying across investment styles - such as value and growth.

Value investing is the art of buying stocks which are trading at a significant discount to their intrinsic value. There are many fund managers who are known for buying unloved stocks in which they see huge potential.

A growth fund approach looks for companies that are expanding rapidly and that look set to significantly grow their earnings over time, reinvesting their dividends in their business rather than paying out profits to shareholders.

Diversify within sectors too. Examples of sectors include technology, healthcare, utilities, construction, financials and mining. Within these sectors investors should aim to own small-cap, mid-cap, and large-cap stocks. 

And if you are dependent on income from your investments, it is essential to have a mixture of investments from which the income is derived.

Make sure you avoid duplication

A common mistake is choosing lots of the same style funds and thinking you’re diversified. For example, equity income funds are hugely popular and those who have benefited from impressive returns might be tempted to buy up lots of other income funds.

But many contain the same stocks - such as Vodafone, GlaxoSmithKline and Royal Dutch Shell - which means there’s lots of duplication and you are not as diversified as you might think. It is far better to have a wider spread of holdings and therefore a wider spread of risk by buying several different types of funds with exposure to different asset classes, sectors and also different countries.

Ms Edwards adds: “Investors have more choices about where to put their money than ever before. Yet it’s worth noting that it can be a mistake to over-diversify and end up holding so many different asset classes or funds that the effect is that they end up with a pseudo tracker-style fund without the normal cost savings. Diversification cannot guarantee gains, or that you won’t experience a loss in volatile markets, but it is the one of the most sensible ways to spread risk over the long term.”

Investors who want a helping hand with diversification can consider buying a multi-asset fund. The fund manager will pick the best funds from each sector, investing in a wide range of assets and securities as an additional way to diversify and spread risk.

Check the levels of diversification of your investments regularly to ensure you avoid any nasty surprises from overexposure.

February 2019