Diversification is not a buzzword – it’s a necessity

Investing is often likened to a journey, with the destination being financial success. Along this journey, one encounters various landscapes as well as pitfalls – of which there have been many in recent years. One crucial strategy that investors must employ to navigate these uncertainties is diversification.

Beyond the elementary understanding of spreading investments across different assets, diversification entails a nuanced approach that goes beyond the surface. In this exploration, we will delve into what diversification is, why it’s paramount for investors, and the diverse methods to implement this strategy effectively.

Understanding diversification

At its core, diversification is the practice of spreading investments across different asset classes and securities to reduce risk exposure. The rationale behind this approach is rooted in the age-old adage: “Don’t put all your eggs in one basket.” By allocating resources across various investments, an investor aims to create a balanced portfolio that is less susceptible to the fluctuations of any single asset, region or sector.

Diversification operates on the principle that not all assets move in tandem. When one investment faces a downturn, another may experience an upswing, mitigating the overall impact on the portfolio. However, the art of diversification goes beyond merely owning different assets; it involves a thoughtful allocation that considers the correlation between different investments.

The idea is to have a lower – ideally negative – correlation between investments. This means all your investments are unlikely to go down or up together. However, in practice this can be hard to achieve. For example, historically when equities have fallen, bonds have risen – although this trend has not been as prevalent in recent years.

Why diversification matters

• Managing risk and volatility: Diversification serves as a shield against the volatility that markets often exhibit. It provides a safety net, ensuring that the impact of a downturn in one sector or asset class doesn’t cripple the entire portfolio.

• Enhancing consistency: Diversification fosters stability by offsetting the potential underperformance of one asset with the positive performance of others, creating a more reliable and steady return stream.

• Capitalising on opportunities: Diversification is principally about risk mitigation; it also opens doors to various investment opportunities. Different assets respond differently to market conditions, and a diversified portfolio can be positioned for investors to capitalise on emerging trends or lucrative opportunities in specific sectors.

By the same token, if one sector, region or asset class is struggling in a certain economic environment – the hope is that other sector will cushion those falls. I like a football analogy for this: a striker may score one week and win man of the match – the next week a defender might get a clean sheet and be the star.

Strategies for effective diversification

At the heart of diversification lies asset allocation – the distribution of investments across different asset classes such as stocks, bonds, and real estate. While stocks offer growth potential, bonds provide stability, and commodities (the likes of oil and energy stocks) can act as a hedge against inflation.

Now that we recognise the importance of diversification, let’s explore how investors – and fund managers –  implement this strategy effectively.

1. Geographic diversification

Beyond asset classes, geographic diversification involves spreading investments across different regions and countries. This strategy helps mitigate the risk associated with a specific country’s economic and political conditions.

Global funds are just one way for investors to gain exposure to a range of geographies. The Capital Group New Perspective fund, for example, has exposure to companies in the US, Europe, Japan and Emerging Markets*.

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Alternatively, you could consider country specific funds such as Rathbone UK Opportunities or Baillie Gifford Japan Trust for more targeted exposure.

2. Sector diversification

Sectors within the economy don’t move uniformly. By diversifying across industries, investors can navigate the cyclical nature of different sectors. For instance, if technology stocks face a downturn, investments in healthcare or energy may counterbalance the losses.

The VT Gravis Clean Energy Income fund is a concentrated portfolio of renewable energy and energy-efficiency related projects. It looks to generate an attractive income, alongside modest capital growth, that should deliver defensive, uncorrelated performance.

Polar Capital Global Healthcare Trust is a unique offering investing in a very specialist part of the market. Holdings in the trust will predominantly come from four sub-sectors: pharmaceuticals, biotechnology, medical technology and healthcare services.

3. Size and Style diversification

Investors can further diversify by considering the size and style of companies. Large-cap stocks, mid-cap stocks, and small-cap stocks may perform differently under various market conditions. Similarly, value and growth investing styles have distinct characteristics, allowing investors to balance risk and reward based on their preferences.

It’s important to remember that company size differs greatly from region to region but here are three funds to consider across the market cap scale:

Unicorn UK Smaller Companies is a high conviction fund investing in genuinely smaller companies rather than mid-cap stocks. With over 20% of the portfolio in engineering*, the fund is an excellent diversifier to any portfolio.

The mid-cap space is a growing segment, but with few funds directly investing in it. The abrdn SICAV I – Global Mid-Cap Equity fills that void for investors. For pure exposure to a quality growth portfolio of medium-sized companies, we feel this is a very competitive option.

T. Rowe Price US Large Cap Growth Equity fund seeks to invest in large US firms that demonstrate innovation and change. It has a very high conviction in the top ten, comprising over 55% of the portfolio with household names like Microsoft, Apple and Mastercard*. The remaining portfolio invested in some 40 names to balance risk and reward, including Salesforce, Spotify and Peloton to name a few**.

4. Alternative investments

Including alternative investments, such as commodities or private equity, can add an extra layer of diversification. These assets often have low correlations with traditional stocks and bonds, offering a unique risk-return profile.

This is common when taking a core and satellite approach. While the bulk of your money may be in a core fund from, say, a global or multi-asset portfolio, satellite positions – or specialist funds – can add some spice to your portfolio.

The WS Amati Strategic Metals fund invests in roughly 40 internationally listed metals and mining companies whose revenues are sourced from the sale of strategic metals. These are metals that have strategic importance to the global economy and future macroeconomic trends. Gold and silver account for roughly 50% of the portfolio today*.

Schroder British Opportunities is another unique offering for investors which seeks to tap into the unloved status of UK equities. We believe the mix of public and private exposure really does allow the trust to stand out from its peers.

Taking a multi asset approach

You can diversify your own portfolio by combining various asset classes, sectors and geographical exposures, depending on your aims and objectives. This will give you the freedom to have a hand-picked portfolio. However, it’s also a lot of work and will require plenty of research.

An alternative – and one that won’t require you having to choose funds – is opting for one of the many multi-asset portfolios. These products combine different asset classes into the one fund. One or more managers will then make the allocation calls required.

The IA Mixed Investment sectors are a good place to start. There are four available sectors that dictate the minimum – and maximum – amounts that funds may hold in equities. For example, M&G Episode Income aims to generate a growing level of income over any three year period, as well as capital growth of 2-4%.

It sits in the IA Mixed Investment 20-60% shares sector and currently has 41% in government bonds, 35% in equities, and 1% in corporate bonds*.

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*Source: fund factsheet, 31 October 2023

**Source: FE Analytics, full fund holdings, 30 September 2023

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