Learn About Investing
Or put a less fancy way: never put all your eggs in one basket.
If you put all your life savings into Apple shares, what happens if Pear comes along and Apple goes bust?
If you spread yourself across a dozen or more different investments, if one of them goes badly wrong it’s not a calamity. Investments move up and down in value at different times and at different rates, so spreading yourself across a bunch of them can make sense.
While diversification doesn’t eliminate risk, it is a very effective way of managing it.
A fund way to diversify
An easy way to diversify is to buy a fund. This is a pre-selected basket of investments of which you buy a share. This avoids the need for you to build up your own diversified portfolio in order to spread the risk.
Funds can be helpful – especially to those new to investing – but bear in mind that fund managers charge a fee for providing the service (even if you never see a bill). Here’s more information on the types of fund available and the fees they charge.
Diversification isn’t just about numbers. Holding more and more investments doesn’t necessarily mean you are adequately diversified and less exposed to risk.
Imagine you had shares in 100 different companies, but they’re all located in Athens and make ice cream. The point is, if your investments are similar – and connected in some way – they may all be exposed to the same set of risks. A cold summer could drive down the share price of all 100 companies in your portfolio.
The financial term for this is correlation. The more share price movements of different companies are aligned, the more they are positively correlated.
Negative correlation, by contrast, means they actively move in opposite directions. In other words, when one goes up in price the other tends to go down. Sales of hot chocolate, for example, could be negatively correlated with ice cream – because hot drinks are favoured during cold weather.
…and how to avoid it
Typically, investors are advised to avoid a situation where the majority of their investments are positively correlated.
This may be obvious in theory but less straightforward to achieve in practice. In today’s global economy just about everything is linked to everything else in some way, even if those connections aren’t immediately obvious. Also, just because two assets have not been correlated in the past, it doesn’t necessarily mean the same will hold true in future.
The reason is that these asset classes tend not to behave in the same way at the same time. In other words, asset classes tend not to be highly correlated. However, after the financial crisis of 2008 all types of asset were badly hit at the same time. That type of convergence doesn’t happen often – and even then some asset classes suffered relatively worse than others. Find out more about asset class risks.
|Seeking diversity||Such as...|
|Geography||in different countries or continents|
|Sector||different products and industries, eg: energy, tech|
|Company size||small, medium, large|
|Currency||GBP, Euros, US dollars|
|Investment style||value, growth|
|Asset type||shares, bonds, property, cash|
No magic number
Having decided to diversify, what’s the right number of investments to hold? Sadly there is no magic number, but a couple of points should be considered.
Firstly, the benefits of diversification diminish as you do more of it. There is a huge difference between spreading risk across, say, ten investments versus just one. Expanding from 10 investments to 100 has less of an impact. And the difference between 100 and 1000 is marginal.
Secondly, it is broadly acknowledged that most of the benefits of diversification can be achieved with as few as 10 to 20 investments – so long as they aren’t highly correlated. See chart.
Risk vs. diversification relationship
While everyday investors are routinely advised to diversify their investments, it is a rule that a few choose to break.
The reason is that there are two sides to the coin. Diversification means that a single bad investment won’t drag your overall returns down too horribly. But it also means a single brilliant investment won’t pull you up much either.
The upshot is that over-diversification can hobble your chances of outperforming the market in a big way. Plus, if diversifying means you select poor investments, it just drags down performance instead of helping. Because of this, people willing to take on the higher risk may choose to concentrate their investment portfolio.