“Don’t put all your eggs in one basket” is one of the best-known rules of investing. It’s simple: if you put all your money into one investment and it fails, you’ve lost everything.
Diversification means splitting your money across a wide range of investments to spread the risk of loss. It sounds straightforward, but it’s easy to get wrong if you’re managing your ISA or SIPP yourself.
In trying to achieve diversification, investors sometimes overcomplicate their portfolios or lose sight of their financial goals. Here’s how to avoid doing that and the mistakes investors sometimes make.
Investing mistakes to avoid when trying to diversify
Inexperienced investors can easily make one of several missteps while building their portfolio.
Studies have found that investment-specific risk can be almost eliminated with a portfolio of just 15-20 randomly chosen investments. While it’s possible to reduce risk further, the diversification benefits diminish rapidly, while the costs and admin can increase.
Investors who prefer a hands-off approach often choose a global tracker fund, like the Vanguard FTSE All-World ETF. While there’s nothing wrong with this approach or fund, holding exclusively shares in large- and mid-cap companies isn’t full diversification.
Choosing three to five funds or trusts can be a good starting point, but remember that some funds are very similar.
For example, beginners often buy multiple funds tracking major indices, like the S&P 500 and the Nasdaq 100. Those two indices contain roughly 85 of the same companies; buying both trackers means you effectively invest in those companies twice, which actually reduces your diversification.
Non-correlation between your investments is a requirement for a diversified portfolio. However, if it were possible to match every holding to another with absolutely no correlation, it would be like betting on both teams in a football match. Your goal is to spread risk, not eliminate it.
Creating your own diversification
To create a portfolio that’s both diversified and aligned with your financial goals, you’ll need to make decisions at several levels.
Different asset types (such as cash, bonds, shares or property) involve different risks. For example, cash is vulnerable to inflation, while shares are exposed to volatility. Higher volatility risk means lower inflation risk, and vice versa – so you can choose a balance that suits your goals and timelines.
Economic trends and currency exchange rates mean that the world’s stock markets move independently rather than collectively. Established markets move relatively slowly, while emerging markets can move more quickly – both up and down. You may prefer one or the other.
