We all have our investment or pension portfolios, and we want the best from them as that’s what brings us the security, and the ability, to do the things we want.
It is often believed, incorrectly, that investment/pension funds are fully diversified when they are not. Read that again please. Some are also over diversified (de-worsification). It’s unlikely you would spot that until there is a large swing one way or another, in which case it is too late.
I won’t get too complicated on overdiversification, but I will explain. Each time we add little additions to a portfolio beyond a point, we may be lowering the ‘potential return’ by more than the ‘risk’ we are lowering i.e. de-worsification.
In a translation of Don Quixote in the 1700s it said: “It is the part of a wise man to keep himself today for tomorrow, and not to venture all his eggs in one basket.”
If you invest all your money in one stock or sector, your portfolio’s success heavily depends on it. Should that investment face trouble, your entire portfolio could take a hit. Diversifying helps spread risk, allowing you to absorb losses in one area while benefiting from gains in others.
For example, investing solely in a tech company might seem promising, especially with the industry booming. However, if there’s a regulatory crackdown or the tech bubble bursts (it won’t be televised in advance), your investment could suffer. But if you spread your investments across industries like tech, healthcare, and consumer goods, a downturn in one sector may be balanced by gains in others. This is how diversification works - by smoothing out financial ups and downs.
Selling ice cream and umbrellas is an example. On a sunny day, your ice cream sales soar, but on a rainy day, umbrellas fly off the shelves while ice cream sales dip. No matter the weather, one of your businesses performs well. By spreading investments across industries or asset classes (like bonds or real estate), you can keep your portfolio stable.
Diversifying across sectors, asset classes, and regions helps protect your portfolio. During the 2008 financial crisis, investors heavily exposed to banking stocks faced huge losses. Those with diversified portfolios, including safer assets like bonds, managed to weather the storm better.
A diversified portfolio balances out the highs and lows. Some years, tech might outperform, while others, healthcare or consumer goods may take the lead. Diversification helps ensure more consistent returns, avoiding deep losses.
What happens when you ignore diversification? The result is potential concentration risk - like betting everything on the ice cream shop and hoping summer lasts forever. If winter comes, your entire business suffers.
For instance, if you invested heavily in oil, and oil prices fall, your portfolio takes a significant hit. Without diversification, your success is tied to one sector, which could lead to lower returns in the long run. In 2020, while some sectors struggled during the pandemic, healthcare and technology thrived. Diversified investors captured these gains while others missed out.
Moreover, a non-diversified portfolio is more volatile. Sharp swings in value can lead to stress and poor decision-making, such as panic-selling during a downturn. Diversifying reduces volatility and encourages steadier investment choices. It’s the same as a boat without stabilisers. That boat will get there quicker, but the ride or safety on some days could be hairy.
Diversification goes beyond owning several stocks. It involves different types of investments – stocks (varying sectors and geographical splits), bonds, real estate, alternative assets and even cash. Stocks tend to offer higher growth but are more volatile, while bonds are more stable with lower returns. Real estate provides tangible assets and potential income.
Geographic diversification is also important. Markets don’t move in tandem. A US downturn may be offset by growth in Asian or European markets.
Don’t think that by spreading across many funds you are diversified. Many are often invested in the same things, and so it all looks rosy until you are battered by a tech downturn and realise your global growth fund was a tech sector. An investment specialist independent financial adviser should have the ability to analyse this and ensure you don’t end up with scrambled eggs when you wanted some poached.
- Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have an investment query, call 028 6863 2692 or email info@wwfp.net
