Diversification

Why is diversification important?

Spreading your money across a range of investments gives you a better chance of growing your wealth over the long term while managing your risk.

If one of your investments is underperforming, while another is performing better, the ups and downs are smoothed out. It helps to manage how volatile your investment portfolio is.

Investments will perform differently year to year. That’s why you need to think long term when investing – that’s five years or longer.

Successful diversification is when your investments don’t move in the same direction – the less those investments have in common, the better.

Think of a football team – one star player alone can’t win versus 11 other players. It takes a team with different roles to play to have the best chance of winning. Diversification is no different. It’s all about building the best team to reach your goals.

How to diversify

There are three main ways of diversifying – through different types of investments, geographies and sectors.

• Types of investments – cash, bonds, funds, shares, and property are the main ones. They’ll all have different risk levels and will be different drivers of returns – each will perform differently at different times.

• Geographies – why stick to one country, when you can have the world? Usually, the best performing stock market will change from year to year so it’s best to have a mix.

• Sectors – a sector is a group of companies which have a similar focus, like technology, pharmaceuticals or banking.

It might feel uncomfortable to put your money into areas which aren’t doing well – but when the tide turns, and it usually does, you’re more likely to be in the right place at the right time.

How different investments work

There’s a wide range of investments to choose from, like shares, bonds and funds. Some are more complicated in how they work compared to others, but we’ll go into more detail later.

Shares and bonds can offer diversification as well as suiting different investment goals:

Bonds are typically less risky and usually pay regular income, but their value doesn’t grow as much as shares can.

Shares offer the potential for higher growth but don’t always pay regular dividends. They’re riskier.

Remember though, income and growth isn’t guaranteed.

It’s also important to hold some cash for a rainy day for emergencies, or if you need the money within five years.

More on how much cash you should holdLearn more about risk

Why sectors are important

You could see sectors as different categories investments are in. They’re usually based on what the company is or where they’re based, or by the type of investment. Both shares and funds can be grouped into sectors, but the sectors used for shares are different from those used for funds.

For example, Lloyds Banking Group shares would be in the Financials sector. Funds usually invest in broader categories to gain diversification so, for example, a fund that invests in multiple countries across the world would be in the global funds sector.

Different sectors perform differently at different times – no one sector will always be on top. That’s why it’s important to hold a mix.

Sector % growth performance over 10 years

Past performance isn’t a guide to future returns. Source: Lipper IM, to 30 November 2024

The global stock market

Investors should keep the size of the global stock market in mind when building a portfolio. You don’t need to necessarily mirror these, but it’s worth keeping in mind how exposed to different countries you are. The US market is the biggest player. Other countries are dwarfed in comparison, with the UK well behind the size of the US.

The makeup is quite different too. A large portion of the S&P 500 index, a collection of US companies, is made up of US tech stocks, being home to big household names like Apple, Amazon, Google-parent Alphabet, Netflix and Meta (Facebook). These alone make up around 30% of the S&P 500.

On the other side of the pond, the UK is quite different. It includes more of a weighting towards oil and gas and financial services companies.

These will change over time as stock markets grow at different speeds, but it can be a useful guide to help decide the weightings in your portfolio.

You can use the Portfolio Analysis tool in your account to check you’re not too exposed to one area.

Asset allocation

Asset allocation is a simple strategy for investing.

It’s all about building your investment portfolio to align with your objectives, risk appetite and target returns. It’s achieved by investing in a mix of asset classes like shares and bonds.

Once your portfolio is built, you’ll need to consider regularly rebalancing it back to its original weightings and risk level. We’ll explain more about this later.

If your circumstances change, we’d recommend reviewing your investment strategy and objectives. All investments should be made with the long term in mind too – that’s at least five years.

Diversifying with funds

Funds offer an easy and convenient way to invest and can be the foundation for a diversified portfolio. Managed by professionals, you benefit from their expertise, knowledge, and research.

A fund is an investment that pools together money from lots of individuals. The fund manager can invest the money in a wide range of investments like shares or bonds, geographies, or sectors.

Investing in more than one fund can amplify your diversification.

Investing in funds isn’t right for everyone though. Remember, investments go down as well as up in value, so you could get back less than you put in.

Learn more about building your portfolio

Funds can be broken down into two types – passively and actively managed.

Active funds

The manager will actively choose and change the underlying investments held on the investor’s behalf, aiming to outperform the market and achieve the fund’s goal.

The manager will continually research and analyse trends and performance, buying and selling new underlying investments as they see fit.

Passive funds

Aim to match the performance of a particular index, like the FTSE 100. These require less day-to-day management so have cheaper ongoing charges.

When you’re diversifying your investment portfolio, a passive fund can be an easy way to gain exposure to an index or market at a cheaper cost. But remember, they aim to track an index or market, not beat it in gains like an actively managed fund.

Avoiding over-diversification

While diversification is an investing essential, we shouldn’t always take a ‘the more the merrier’ approach – you can have too much of a good thing.

There’s such a thing as over-diversification. While it reduces the risk from holding too few investments if you hold too many, it can be hard to keep track of their performance. Also, if your funds have similar objectives, you could be holding a lot of the same thing.

The second and third fund you add to your portfolio gives much greater diversification benefits than the 20th.

There’s no magic number for how many holdings you should have but it’s unlikely a portfolio with 20 or more funds is the best option.

Know the costs

Costs don’t just include charges like trading commissions, there’s also the time involved. Most of us have jobs, families and other things to fill our time besides poring over company accounts.

Keeping track of a large share portfolio, and hunting for ideas, can be a full-time job – this is where a fund manager could help. At a certain point, the diversification benefits just don’t justify all that extra effort.

But if you end up investing in numerous actively managed funds to diversify, you could just be creating an expensive tracker fund.

You’ll need to think back to your reasons for investing in the first place and see which funds match those objectives too.

Reviewing and rebalancing your portfolio

Once you’ve built your portfolio, it’s important to check in on your investments from time to time to make sure they’re still right for you. There’s no hard-and-fast rule on how often you need to review your portfolio, but we think twice a year is sensible – once a year at the very least.

Review your investment portfolio