Why diversify?

All investments carry risk. The value of your portfolio can go up and down, and you may get back less than you invest.

When it comes to your portfolio, holding a single stock is risky. What if the company’s earnings plummet? What if it’s fine but the sector it’s in suddenly falls out of favour? What if the country it’s listed in goes through an unexpected shock, like war? Unhelpful influences can come from a number of angles.

Now imagine you held a second stock in a different sector or country, maybe even a different asset altogether like a bond, or commodity like oil. Instantly, those initial outside influences don’t hold the same potential for damage. Your new holdings will carry their own risks and opportunities but, again, they will be different than your first stock.

It’s this concept of spreading risk across a number of assets, rather than concentrating it between a few, that lies at the centre of diversification.

Achieving a good level of diversification isn’t just a case of constantly adding a wild range of assets to your portfolio. The goal should be to let your preferred assets get to work in the knowledge that each has its strengths to showcase in different market environments. Like a good team at work or on the sports field, you should be able to identify unique opportunities and drawbacks to each holding, and where its stablemates can make up for that.

A decent starting point can be to make sure your portfolio is well-represented across geographies, asset classes, company sizes and maybe even strategies if you hold funds with different objectives. That doesn’t necessarily mean an equal-weighting to all major country indices but it does mean populating your portfolio in full knowledge of how the globe is represented.

This is where diversification becomes a very personal thing.

There’s no definitive answer here because there’s no one-size-fits-all objective. We all have different approaches to investing and interests in different areas, so we need different assets to make it personal based on our risk appetite. Some people might find a generic global ETF gets them a lot of the diversification they need in one holding. Others focused on only buying undervalued shares might need a lot of them in case it takes the companies ages to turn around, if they ever do.

In general, it’s a good idea to have different countries and sectors represented in a way that lets you explore a theme you actually want to and not penalise yourself for doing so, if it goes through hard times.

It becomes less a question of ‘how many?’ and more one of ‘what do my holdings give me, and where are the gaps?’

Once you start thinking this way, you might find that, even though you hold a decent amount of stocks, some of them have similar characteristics - not a bad thing necessarily but not helpful for diversification.

Your portfolio doesn’t exist in a vacuum so don’t forget to factor in your personal situation too. Your investment time horizon, your ability to save and invest, and appetite for risk all matter here and need to be reflected in the assets you hold.

It may be that you end up dialling one or more of these elements up or down as you solidify another. For example, if you want to take the lowest level of risk possible (which comes with lower prospective returns) you might need to increase your time horizon or increase your starting amount and regular investments to meet your financial goal. On the other hand, if you don’t have a lot of cash to begin with but have punchy goals, it may be that you need to extend your time horizon or think about upping the risk levels to get there.

There’s a push-pull relationship here that tends to end in compromise. That can then inform the assets you choose and how diversified they need to be, with your goal, tolerance for risk and timeframe in mind.

Once you have the asset mix that suits your investment personality, try to not to fiddle with it too much. It’s there for a reason and little changes along the way can end up transforming the whole risk profile of the portfolio.

It can be tempting to add in the odd stock or sell something that isn’t shooting up the page but, just like a tense game of Buckaroo, you need to consider what your next action will do to everything else.

That’s not to say you can never touch your holdings ever again. If a stock story has played out or the company stops doing what you bought it for, it might not meet your needs anymore.

On that note, when your needs and life goals change, check in and see if your portfolio still suits. If you have achieved a financial goal that required a high level of risk, it may be that your next one needs a completely different asset mix.

Another prompt to check in might be a big change in the global financial picture. A good example here is how we’ve changed our view of cash over the years. After the financial crisis, interest rates were nailed to the floor, making cash savings extremely unattractive. Inflation in the post-Covid world brought those rates up so suddenly cash was back on the table, with a lot of people reconsidering what role it could play in their portfolios.

Even these shifts tend to give way to much longer trends in terms of asset performance and accompanying risk levels so it’s still a good idea to keep an eye on the long term and keep your own personal reasons for investing top of mind.

The last thing you want to be doing is chopping and changing every time something happens in the world - that’s what a well-prepared portfolio is designed to deal with. Once you’re happy with it, don’t tinker.

If you’ve chosen to minimise risk it can be disheartening to see market rises leave you behind at times. However, when the market dips you should hopefully not suffer as much if you stick to your own plan. Don’t get swayed by short-term market movements - your portfolio should reflect your needs and your personal objectives over the long term.

Don’t over-diversify. Your portfolio shouldn’t become a dumping ground for all of your stock ideas over the years. And constantly adding stocks doesn’t necessarily mean your portfolio is any more diversified.

For example, adding lithium stock after lithium stock might help if one of them performs better than the others but what if the price of lithium plummets?

Likewise, investors in UK equity income funds over the past decade may be surprised to lift the bonnet and see the exact same names in most of their funds - actually increasing their exposure to these single names, not reducing it.

It’s why a lot of people tend to adopt a ‘core and satellite’ approach, with some major-market ETFs at the centre and some smaller holdings in select stocks, bonds and commodities on the outside.

Important information

When you invest your capital is at risk. The value of your investments can go down as well as up and you may get back less than you invest.

This article is meant for educational purposes only and should not be read as personal investment advice. Individual investors should make their own decisions or seek independent advice.