How to Diversify Your Investments

Diversification is the first rule of investing. But how do you know if your porfolio is truly diversified? 

Grace Oliver 21 June, 2021 | 11:44AM
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The most common piece of investment advice we hear is to make sure you diversify your portfolio.

Naturally the first thing you might consider is to spread your money across multiple regions and different asset classes such as stocks, bonds and property. But it can still be easy to wind up with a portfolio of very similar funds without realising.

Are You Diversified?

Ideally the way to combat this is to look at every fund individually and check out every single stock each fund holds. This is not, however, particularly easy for DIY investors. Not to mention the time and effort involved in carrying this out. A fund portfolio is always subject to change, and funds can buy or sell a stock before you have even finished looking through the entire portfolio.

Home bias is one factor which could be hindering your diversification. This is our natural tendency to invest in stocks on our home market, where we may feel more familiar with the companies. It is no surprise this is a common bias with investors (we have recently looked at how biases can impact your returns) for example Alibaba and Tencent are not as known in the UK as Unilever and Shell, so you might feel more comfortable investing in the latter two. 

Diversification is also not as simple as picking a US-based fund and a global fund. A large proportion ofgGlobal funds heavily invest in the US, so there is likely to be significant overlap in their holdings.

So how can you make sure your portfolio is truly diversified? Here are some tips: 

Invest in Different Styles

Picking funds with different investing styles, such as value or growth, is one way to help ensure you are investing in different companies. Value managers often looking for out-of-favour and unloved stocks, while growth managers may invest in stocks which are already on an upward trajectory. 

Darius McDermott, managing director of Chelsea Financial Services, says: “If you have two growth funds, one global and one US, they are bound to have some overlap of holdings. If you have some growth and some value though, they are likely to be different.”

The fund management group is also a consideration here. Some groups are known for investing in a particular style. For example, many people have seen the sensational returns of Baillie Gifford in recent years, but the similar styles of investing across the group should be noted. Holding funds from just one group could leave your portfolio biased to a certain investment style, while incorporating too many could mitigate the "alpha" that some managers aim to deliver. 

Invest in Different Regions

Spreading your money across different geographies can help diversify your portfolio - but only if you do it right. The US, for example, makes up 55% of the global index so there's no point owning a US fund and a global fund. But, says McDermott, "you could go for single geographies or regions and have a Europe, Asia and US fund in the mix".

But Rathbones head of multi-asset David Coombs says that having too many global and specific country funds in your portfolio is likely to result in "overdiversification". He says: "The other mistake is to buy a value and growth fund in every region. Just go out and buy an ETF in that case because that's effectively what you're going to end up with. If you blend styles then you end up with the index and owning the most expensive tracker in the world."

Invest in Different Sized Companies

While a global fund and an Asia fund are likely to have some overlap in their holdings, a small-cap fund which focuses on smaller companies and a large-cap fund, which focuses on the biggest businesses, will hold very different stocks. 

Investment expert Adrian Lowcock says: “A UK small cap fund is unlikely to have much overlap with a Japanese equity fund for example." Focusing on market cap spectrum is more likely to give you diversification than choosing specific regions or sectors.

Invest in Different Types of Asset

Investing in different assets is one common way to diversify. Historically, for example, when equities have risen in value, bonds have fallen, so investors have been protected by owning a bit of both. That's less true today, but having a mix of different assets is still a good way to build some protection into your portfolio. 

The range of assets available to investors doesn't just stop at equities and bonds either; gold, property, renewable energy, infrastructure, commodities all behave in different ways and will do well at different points in the economic cycle. 

What Else? 

Finding out about a fund’s exposure is not always difficult. Fund documents including factsheets and manager commentary all offer information on how the fund is run, its style and holdings. While style is not always obvious to spot, looking at the stocks a fund owns may give some indication.

Lowcock adds: “Consider performance of the funds as well, with a particular focus on those funds with similar performance as this could be a sign of similarity.”

While past performance is no indication of future returns (the other most common bit of investment advice), it can indicate how correlated the stocks you own are if all the funds you own tend to outperform and underperform the market at the same time. 

But is there really a danger of overexposure, and what could happen? McDermott says: “The danger of not really being diversified is that you are reliant on a handful of stocks or assets doing well. And if you hold similar funds, they will all move in the same direction at the same time.”

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Grace Oliver  Grace Oliver is a freelance financial journalist