We’d all love to be able to make the investment decisions we would have when we’re later armed with hindsight, but because no one’s able to see into the future, it’s simply not possible.
In the absence of a crystal ball, having a well-diversified portfolio is one of the smartest long-term investment decisions you can make.
What is diversification?
Diversification is one of the most effective ways to manage your investment risk and provide more stable returns. It reduces the amount of risk you’re exposed to, and gives you peace of mind by removing some of the guesswork from investing while increasing your potential returns. It’s vital to your long-term investment success.
To achieve this, your money is spread across a wide variety of investments, covering multiple asset types with no bias to a specific industry or geographic area.
Different assets will react differently to the same economic event, reducing the risk of your entire portfolio being wiped out by a single event or market downturn. It also removes your reliance on a single market or asset type to perform well for your portfolio to yield a good return.
In essence, it’s like having a little of your money in lots of different pots, rather than putting all your eggs in one basket – an approach which is sensible for many other aspects of life too.
How to diversify your portfolio
Diversification, in its very simplest form, could be compared to running a seasonal business, perhaps selling sunscreen and flip-flops.
In the summer months you’d probably do a roaring trade, but what about when the weather isn’t so great? You’re far less likely to experience high demand for these items when it’s raining or cold. However, if you branch out to selling wellies and scarves too, you’d expect a good level of sales, whatever the weather.
Of course, you can’t control the weather or the markets, but you can be prepared for all eventualities. By diversifying your investments, you can smooth out the effects of one asset or market performing badly, while still reaping rewards when others do well.
This means you’re not gambling on how a single element of your portfolio will perform, reducing your exposure to market volatility.
There are several ways you can create a diversified portfolio including by market, by country, by asset class, or a mix of all of these.
The portfolios we invest our clients and our own money in are highly diversified, including 47 countries, and more than 20,000 individual equities and bonds. This maximises the benefits available by investing in the global markets.
Putting it in perspective
World equity market capitalisation as at 31 December 2020. Source: Dimensional Fund Advisers
It’s best to spread your risk by investing proportionally in the global market. This image shows a geographic representation of the main markets as a proportion of the total world markets.
If you choose to invest more than 4% of your portfolio in the UK market, you’re effectively placing a bet that the UK market will outperform the rest of the world.
This builds additional risk into your portfolio. You have to hope that your decision to go ‘overweight’ in the UK was the right one to have made. Research shows that it’s better to invest proportionately to produce a steadier return.
Stop trying to predict the future
The very nature of forecasts mean they’re based on what is known, namely the past. ‘Experts’ will predict what’s coming next, but of course it isn’t possible to see the future.
According to Yale University chief investment officer, David Swensen: “Sensible investors prepare for a future that differs from the past, with diversification representing the most powerful protection against errors in forecasts.”
Diversification helps take the guesswork out of investing and means you can be more prepared for the unexpected. You might be surprised to learn that the US market actually went up the day that Russia invaded Ukraine. Many forecasters have also been surprised by the recovery we’ve seen in the UK market since the decline we saw a few weeks ago.
The table below shows the past performance of different investment sectors. Each colour represents a different sector, with the sector that performed best each year at the top of the table, and the sector that performed worst that year at the bottom.
If you select a colour in the first column and follow its performance across the table, you’ll see that the sector that performs best one year may perform very poorly the following year, and vice versa.
Unfortunately, past performance isn’t a clear indicator of future returns. But it does give a very clear indication of how random returns can be from one year to the next.
Returns by market index. Source: Dimensional Fund Advisers
Research shows it’s not possible to consistently select in advance the top-performing company, business sector, country, or asset class. Diversification smooths out the impact any of these elements will have on the performance of your investment portfolio, which can make your investment journey much more comfortable.
The graphic below demonstrates this. Holding A has performed the best, and holding C the worst, but they’ve experienced their biggest ups and downs at opposite times. This means the average of the holdings in the portfolio equates to the smoother line in the chart below.
Source: Dimensional Fund Advisers
Even experts like Warren Buffett can’t anticipate how unforeseeable circumstances will affect companies. So, it doesn’t make sense to invest in a strategy that claims to have a knowledge of which the “right” companies are, and how they’re going to perform within a specific time frame. The reality is no one knows.
If you’d like to find out more about the benefits of a well-diversified portfolio and how to remove some of the guesswork from investing, please contact us at your@lifemattersfp.flywheelstaging.com, or call 01202 025481.
Please note, the value of your investment can go down as well as up and you may not get back the full amount you invested. Past performance is not a reliable indicator of future performance.