Building a diversified portfolio

The purpose of diversification is to maximise investment returns by taking on an appropriate level of risk based on your risk profile, goals and time horizon.

What do we mean by diversification?

A portfolio can be diversified in two ways: between asset classes and within asset classes. The first decision is how much of your money should be allocated to different asset classes such as equities, bonds, property, commodities and cash.

The second step involves spreading your capital within asset classes and reduces the investment specific risk. For example, equities can be diversified further by geography and bonds by the type of instrument.

Diversiication Chart

Why diversify?

The key reasons are to reduce risk and capture opportunities. When thinking about risk there are two areas to consider; risk capacity (the risk you need to take to meet your goals but also how much you can afford to lose) and attitude to risk (more about your personality and the level of risk that will let you sleep at night).

Combining asset classes that have low or even negative correlation can reduce the volatility (a measure of risk which calculates how much returns fluctuate over time) of your portfolio. Examples of a lack of correlation, when assets do not perform well as the same time, could be long-dated Government Bonds against equities. Many experts believe careful asset allocation is even more important than the choice of individual Funds or stocks.

The other reason why it makes sense to not have all your eggs in one basket is the opportunity to take advantage of geographic regions with superior investment prospects. By sticking to your home market, you may miss out on growth, or indeed income, opportunities elsewhere. A Fund Manager adds another layer of diversification across industry sectors and individual companies.

How do I ensure my portfolio is sufficiently diversified?

You can use our :explore tool to filter Funds by factors such as: IA sector, yield, past performance, style and Morningstar rating. A well diversified portfolio can be achieved with a maximum of 20 Funds, or fewer if you take a multi-asset approach.

Try to avoid Funds which duplicate holdings as you are creating more work for yourself; check out the top ten underlying holdings as displayed in the Fund fact-sheet. If you have a large number of actively managed funds it may be cheaper to holder tracker Funds instead.

If markets have had a strong run or you are looking to buy Funds with high volatility (reflected in the FE risk rating shown) you could consider a strategy of drip-feeding money in on a monthly basis.

What does a well diversified portfolio look like?

A balanced portfolio should ideally have a blend of riskier and defensive assets (the proportions will be personal to you) which are not closely correlated. Overseas exposure can be obtained through a global Fund or single country Funds but bear in mind that Emerging Markets can be more volatile than developed markets.

Global Funds usually pay attention to the weightings in their benchmark index and adjust positioning according to their current views on the economic outlook. However, like many private investors, you may wish to have a ‘home bias’, or a greater proportion in the UK, thus avoiding any currency risk.

If you are new to investing you may wish to opt for a multi-asset Fund where the Fund Manager takes care of the asset allocation on your behalf. If you prefer to do it yourself, the ideal number of holdings will depend on the size of your portfolio and the amount of time you can devote to managing it.

Diversiication Chart

Multi-asset Funds

Multi-asset options can be found in several IA sectors: Mixed Investment, Flexible Investment, Target Absolute Return and Specialist. Both active and passive solutions are available.

Some are linked to risk profile: you select the most appropriate fund from a range covering cautious to adventurous. Others have target returns, for example inflation +3%.

Target absolute return multi-asset Funds aim to protect capital but this is not guaranteed and they may make small losses in falling markets.

Keeping your investments under review

Markets are constantly evolving so you may wish to reduce holdings which have performed well and add to those which have lagged. At Fund level, a strict sell discipline can help you remain in control but, at the same time, don’t be tempted to trade too frequently as there is a tendency to over-react to short term events.

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