Diversification provides two key benefits for investors: increasing exposure to high-performing assets and reducing the risk of over-concentration. But what constitutes a suitable spread of investments? How do you choose what to include in your portfolio, and are there any golden rules to observe?
In this article, we explore why diversification is important, reveal how to combine different asset classes and consider other ways to ensure some variety.
Please remember that the value of investments will fluctuate and returns may be less than the amount originally invested. Tax treatment depends on your individual circumstances and tax rules can change. Chelsea does not offer advice and so if you are unsure of anything please contact an expert adviser.
What is diversification?
The concept is to hold a variety of assets with different risk/return profiles so that losses in one area are offset by gains in others. The focus is on combining holdings in a portfolio that respond differently to the economic backdrop. It harks back to the advice of not putting all your eggs in one basket.
Why is diversification important?
Diversification is regularly touted as a golden rule of investing – but what are the main benefits, and how can you ensure a suitable spread of assets? Well, a diversified portfolio is less likely to be hit should an asset class or sector take a hit, as it will have other exposures that are unaffected.
Dangers of not being diversified
Being overly concentrated in particular sectors can seriously harm your wealth. Many banks, for example, were badly affected by the Global Financial Crisis of 2007-2009. Likewise, excessive enthusiasm for technology stocks during the dotcom boom left many investors suffering heavy losses when the bubble burst.
Risks of diversification
Of course, it’s important to acknowledge that there’s a price to pay for having a spread of assets. When equity markets are roaring ahead, diversification will limit your potential upside. However, whether this is acceptable will depend on your long-term objectives and risk appetite, as well as on other assets and investments. This is why you need a plan.
Be clear on your goals
Before talking about diversification, investors must know what they’re trying to achieve and how much risk they’re willing to take. When developing a portfolio, it is critical to select a combination of assets that offers the best chance of meeting your long-term objective.
Types of diversification
It’s important to recognise that there are different types of diversification:
- Asset class
- Geography
- Sector
- Industry
Asset class
This is the first level of diversification. It usually involves having exposure to equities, bonds, property, commodities and cash. The hope is that should stock markets tumble, then holdings in the other key asset classes will help protect the overall portfolio.
Geography
As the name suggests, this is spreading assets across countries and regions. This helps protect the portfolio from political instability, currency fluctuations and regulatory changes. Geographic diversification is particularly important if you have emerging market holdings.
Sector
It’s easy for portfolios to get overly skewed to a handful of sectors, particularly when so many of the world’s largest companies are in areas such as technology and energy. You need to identify which sectors offer the best prospects and ensure the chosen funds align with your thinking.
Industry
This is a narrower definition of sectors. For example, within technology, you can have semiconductor manufacturers, software designers, hardware providers and IT services. Fund managers can enjoy success by picking little-known companies that can benefit from thriving industries and sectors.
How to build a diversified portfolio
The first option is to construct a portfolio based on your individual investment objectives, attitude to risk, and views on the world. Everyone is different – and it’s worth seeking independent financial advice – but here are a few rough asset allocation splits that may suit individual needs:
- Conservative investors
- Balanced investors
- Aggressive investors
Conservative investors
While they obviously need growth, their focus will be more on capital preservation, so their overall portfolio won’t be wiped out by a stock market crash. Broad asset split: 60% bonds; 30% equities; 5% property; 5% cash or money market funds.
Fund suggestions might include: Artemis Corporate Bond and Rathbone Ethical Bond, along with equity income portfolios, such as Fidelity Global Dividend and Guinness Global Equity Income. TM Gravis UK Infrastructure Income could also be included.
Balanced investors
These investors will want to strike a balance between growth and stability. Therefore, a portfolio needs to have a mix of exposures, albeit with slightly more in equities. Broad asset split: 50% equities; 40% bonds; 5% property; 5% commodities.
Fund suggestions might include: IFSL Evenlode Global Equity is a solid core holding, along with regional exposure such as Fidelity European. Flexible bonds could be a good fit, such as Aegon Strategic Bond and Invesco Tactical Bond.
Aggressive investors
These have a higher risk appetite and want to maximise their portfolio’s growth. This means they’re unlikely to have any bond holdings, and if they do, it will be in high-yield bonds. Broad asset split: 90% equities; 5% property; 5% commodities.
Fund suggestions might include: M&G Global Emerging Markets is worth considering, alongside country-specific funds such as Chikara Indian Subcontinent and Liontrust UK Micro Cap. Meanwhile, Landseer Global Artificial Intelligence can provide some thematic exposure.
A one-stop-shop option
Another option is the VT Chelsea Managed Funds range. This is a complete investment solution consisting of four award-winning funds designed by our in-house research team. Launched in 2017, the VT Chelsea Managed funds have delivered sector-leading performance with some of the lowest charges for active funds of funds in the industry.
Pick and choose from the fund range to match your own risk level and requirements. Fund can also be mixed and matched in any way you like to suit your personal needs.
