Investment diversification explained

Everything you need to know about this key approach to investing

Ever heard the phrase ‘don’t put all your eggs in one basket’? When investing, this is especially important because all investors need to focus on diversification, the term for spreading your investments between different types of ‘assets’. 

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Here at Be Clever With Your Cash, we’re not regulated to give you financial advice. We aim to give you the facts about a provider or investment but it’s up to you to decide if it’s suitable for you. If you’re looking for more personalised guidance, find a financial adviser who can give you specific advice. Remember that your capital is at risk when investing — don’t invest more than you are prepared to lose. 

Different types of investments

Assets are the investment categories into which most of our money is invested. The four main types are cash, bonds (loans to governments or companies), shares (investments in companies listed on global stock markets) and property (commercial property such as offices and industrial buildings). 

But you may also come across commodities (raw materials and agricultural products that can be bought and sold, such as gold, copper or coffee and wheat) and private equity (companies that are not listed on stock exchanges).

No one asset class is intrinsically better because each one works for different goals and risks. Some may perform better than others, but the trade-off is usually that you take a higher risk of losing your money when investing in them. Cash and bonds are generally lower risk but lower return than shares and property, for example. 

Getting the right balance

It’s all about getting the right balance between different assets (and their risk profiles) to suit your own specific investment goals and your risk appetite, which is also personal to you. 

In theory, if you get diversification right, then your overall investments won’t all fall and rise at the same time. This can give you a smoother ride and means you might worry less when stock markets have big falls.

Some asset classes have different categories within them, for example, shares and bonds can be traded on UK and overseas stock markets. 

Diversifying shares

If you’re investing directly into shares, it’s a good idea to spread your risk by holding shares in at least 25 companies in different market sectors, such as consumer, financial and industrial companies. Many investors hold more than 25, maybe 50, but the more companies you hold, the more time you will need to spend monitoring your investments.

There will be annual reports to read and company results to follow, plus all the media coverage relating to each company. It can be a fascinating and enjoyable hobby, but it’s not for everyone. We have a full guide on the difference between shares and funds if you want to know more about them.

Diversifying funds

If you invest in funds, the diversification between companies is done for you by a professional fund manager. You may want to spread your money between a few funds. 

Fund managers can make the wrong call, resulting in them underperforming similar funds or (worse) their stock market-indexed benchmarks. There’s also the risk that fund managers can fall ill or go through mental strain that affects performance, or simply leave suddenly due to a family crisis. 

If one of those things happens to one of the funds that you hold, resulting in poor performance, high levels of diversification between funds would mean that underperformance of that particular fund doesn’t affect your portfolio so much. 

If you hold passive funds that track stock markets, it’s a good idea to hold a few that track different indices in different parts of the world so if one country or region has an economic or political issue that affects share prices, your other holdings may hold up better. There are several different types of funds that you can invest in, and we have a full guide on them to help you choose what to invest in.

Too much diversification?

Investors have a tendency to collect funds every year, choosing fashionable fund or ones that are being heavily marketed during ISA season, the months before the end of the tax year, when investment companies are trying to persuade you to use your tax-advantaged £20,000 Individual Savings Account allowance. Don’t get drawn into the trap of collecting too many funds over decades of investing.

It’s common for some investors to reach their 60s holding 30 or even 50 actively managed funds. Paying lots of different managers fees to try to outperform the stock market might seem like a good idea. But that is very likely to result in something called ‘diworsificaton’. 

Your portfolio effectively becomes a tracker fund, delivering average performance over time, but has higher charges eating into performance. You might as well buy one cheap global tracker fund that gives exposure to the average performance of the world’s stock markets. 

Also monitoring 30-50 funds even twice a year (probably the minimum requirement) would take hours to do properly. First, you’d need to check the managers and strategy haven’t changed, but you’d also probably need to check the underlying holdings and any cross over between your funds. 

Rebalancing your portfolio

Then there’s rebalancing to do: if the overall asset allocation moves, say in favour of shares over bonds, or US shares over UK shares. You’ll have to buy or sell holdings to bring it back to the original split of assets. And all the buying and selling can raise the overall cost of investing.

For an investor with a £100,000-plus portfolio, advisers say holding between 10 and 15 funds is sufficient. They recommend that your minimum fund size is at least 5% of your portfolio, so that’s at least £5,000 invested in every fund you own. Once your portfolio grows larger it might also be wise to limit exposure to any single fund to no more than 15% of your overall portfolio – lowering the risk of one fund underperforming. 

Some of the DIY investment platforms manage to create highly diversified model portfolios using five to nine funds. They say it’s sufficient diversification to allocate money to different types of funds and global markets without doubling up too much on the underlying investments.

What does a good diversified portfolio look like?

To view some typical examples of portfolio diversification, look up the MSCI PIMFA Private Investor Series. This shows how the UK’s wealth managers typically invest portfolios on behalf of their clients. There are five indices that suit a range of risk appetites and they are updated regularly.

The one in the middle is the MSCI PIMFA Private Investor Balanced Index, which aims to represent the strategy of an investor seeking a balanced approach between income and capital growth. It has 42.5% in international equities (another word for shares), 17.5% in UK equities, 22.5% in bonds, with 12.5% in alternatives, 2.5% in real estate (property) and 2.5% in cash.