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Why diversify?

It goes deeper than eggs and baskets

Daniel Lane, Fidelity Personal Investing, 12 September 2019

Getting the balance right between risk and reward lies at the heart of all levels of investment. Where you sit comfortably on the scale informs what you’re prepared to put up with, to get something out of it all.

It’s important to get used to the idea of risk as an essential part of investing. We tend to get worried when we see the word but remember - it’s this very phenomenon that lets share prices rise as well as fall. So, it’s about managing sensible risk, not fearing it.

Getting the assets right

In the long run, the mix of assets you hold, like company shares, bonds and property, will have a greater bearing on your portfolio’s returns than anything else so it’s vital you get the blend right for you. Each has its own inherent level of risk attached - so why wouldn’t we just choose the lowest? Well, like we just said, there’s opportunity out there too and the assets more exposed to downside risk also often have the greatest opportunity for reward.

Spreading your money across them lets you access the possibility of returns across various asset classes. It also helps protect against downturns in one specific area.

This is the basis of diversification and we use it in other areas of our lives too – think of why you might use sun cream and a parasol at the same time – you’re managing the risk of getting burnt by using preventative methods that don’t depend on each other to work. If one fails you have a back-up and if one is more effective than you first thought it brings a bit more peace of mind.

The same is true for a well-diversified portfolio – including a range of assets that act differently from one another means mitigating against the effect that one sole part of your portfolio has over the whole thing. Put simply, if one of your investments should underperform, its teammates will hopefully pick up the slack.

Get the funds right

Passive funds provide instant diversification, as they replicate their indices. Take the Fidelity Index UK Fund, which tracks the FTSE All-Share Index, as an example - the lion’s share of FTSE 100 companies’ earnings comes from outside the UK, meaning that investors achieve international exposure simply through one passive fund.

However, where markets are particularly under-researched or inefficient, active management can shine, as well as in markets where good companies’ performance is muted in index trackers by the laggards. In markets like these, passive funds will buy all the problems of the market as well as all the top performers. 

Using a combination of both strategies helps to protect against the negative performance of one manager, or a broader drop across the whole market. While one falls, the other should be able to hold the fort, if chosen with this eventuality in mind.

Often, if an active manager’s approach falls out of favour for a period you’ll look to another manager with a different approach that may start to shine. By diversifying your holdings you increase the chances that at least one of the cylinders is firing at all times.

Don’t overdo it

It can be easy to equate holding more funds with higher levels of diversification but this isn’t always true. Often, funds will hold the same companies because managers will have similar ideas and there is a finite number of high quality companies to choose from. In this instance, holding both funds will mean you actually have a higher exposure to the underlying company.

Try to avoid overlapping these holdings, especially if you are investing for income. As an example, UK equity income funds can have very similar holdings because the number of dividend-paying companies in the UK has become increasingly concentrated in recent years. If your funds are too similar, any unwelcome drops in dividend payments will have a greater impact on your overall income stream.

Important information The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Reference to specific securities/funds should not be construed as a recommendation to buy or sell these securities/funds and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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