Why diversification is an investor's best friend

At its most basic, having a diversified portfolio is simply the investment version of the phrase ‘don’t put all of your eggs in one basket’.

But true diversification is more than just buying shares in lots of different companies. A properly diversified portfolio usually includes different types of assets, as well as investments in different types of businesses from different areas of the globe. 

Creating a diverse portfolio doesn’t need to be a complex science. You just need to make sure you at least have the following areas covered.

Diversification of asset classes

The five main asset classes are stocks and shares, corporate and government debt (bonds), property, commodities and cash. Different types of asset react in different ways to the same market forces - for example bonds and shares often (but not always) move in opposite directions, meaning that adding bonds to an equity portfolio will decrease its volatility.

Figures from Barclays Equity Gilt Study show that, although historically shares have outperformed government bonds over most periods, different asset classes can perform very differently over a period of time. For example, over the last 10 years, government debts (gilts) have risen 4.3 per cent, compared with shares at 2.5 per cent, while the value of cash has fallen 1.3 per cent in the same period.

Of course, having lots of different asset classes is not a magic cure for your portfolio as on rare occasions they can all suffer simultaneously. But a mix of asset classes will certainly help towards protecting you against the ups and downs of the stock market. 

Diversification of sectors

When the stock market rises or falls, not all stocks and shares will move in the same direction. That’s why it is worth diversifying your investments so that you invest in different types of companies across different sectors.

There are many different ways of classifying sectors and types of investment, but one of the most common is ‘Cyclical’ versus ‘Defensive’ stocks.  Cyclical stocks tend to do well when the market is rising, and include technology shares, while defensive stocks include tobacco and pharmaceuticals, which tend to hold their value as the market falls.

Having a broad mix of sectors within your stocks and shares investments will help to ensure they perform well over different economic cycles.

Diversification across the globe

Stock and bond markets in different parts of the world perform differently at different times. Experts often group countries with similar economic characteristics together when talking about global diversity. These might include BRICs (Brazil, Russia, India and China) or Emerging Markets (a description of less developed countries). A broad spread of global exposure can help you to deal with long term and short term volatility - for example the impact we have seen recently due to Brexit in the UK.

How ETFs and funds can help you

Spreading your investments across different asset classes, sectors and regions is certainly the best way to become diversified, but knowing exactly how to do is probably a bit more challenging. To find and research all the individual investments needed to make up your diversified portfolio would take a long time and not be particularly cost effective either.

The solution to this problem is using a type of investment that allows you to access a broad range of equities, bonds, sectors, commodities or regions in one ready-made basket, such as an exchange-traded fund (ETF) or a traditional fund. Not only does it save you time, but also money, as you’ll only be paying for investing in that one particular ETF or fund.

Diversification and regular investing

Regular investing helps to reduce investment volatility, thanks to what is known as “pound cost averaging”. When stock markets fall, your regular monthly payment buys more shares or fund units. When markets rise, fewer shares and units are purchased. This reduces the risk of an investor putting a large sum into the market at the wrong time.

This can further steady a diversified portfolio, as long as you invest in all parts of your portfolio at the same time.

However, since some parts of your portfolio are likely to perform better than others at various times, it is important to review the entire portfolio regularly and to rebalance it if outperformance in some areas means that you are now too heavily invested in one area of the globe or one asset class.