30 Nov 2024

Investment: Diversification

This month, we will examine the concept of diversification in investments. Most of us have heard the expression, “don’t put all your eggs in one basket”.  But, the reality of what “baskets” we have and how they align with each other, is not always clear.

Because this newsletter reaches a wide audience, many of whom do not spend their day to day in the financial sector, the below is deliberately a simplification of sometimes quite complex topics. We love talking about this stuff, so if you want to delve deeper, we would love to hear from you.

Diversification in investments can help to address a wide range of risks, including geographic, political and macroeconomic, liquidity, asset-type, and sectoral risks. We consider all of these below.

Back to eggs and baskets. For many people, the first and largest ‘nest-egg’ they have is their own home, which is usually a significant chunk of their net worth. Geographically, this home is located on one street and sometimes in one shared building, in one town or city. It is therefore subject to some very specific risks – including actions by a local council or city mayor, and also UK national government risks of unhelpful or unwise changes by a Chancellor or Prime Minister (for example, Kwarteng and Truss – not exactly ancient history!) Added to this are the macroeconomic effects often tied to the same geography: when the UK economy falters, house prices tend to stall, and rental yields on property can come under pressure.

Then there is your source of income, which for many, is firmly rooted in a job or business in the UK – often subject to the same geographic and political risks as your home. It might not look that way, but your job and home are eggs in very similar baskets of risk.

Many other investment types offer the opportunity to spread your risk around the world – including equities (stocks / shares) and bonds (government and company debt issue) as well as other alternatives. However, care needs to be taken, as many individual and even institutional investors are prone to “home bias”. This means they tend to overinvest in local companies and markets, as well as their own government’s bonds, perhaps because of the comfort that comes with familiar language and household names. This is not a peculiar thing to the UK, with small countries for example in Scandinavia and Asia, often having significant over-investment in their local stock exchange.

While the UK stock exchange, which in total makes up approximately 4% of all global stock market capitalisation, is home to many very international businesses, so are nearly all the other major stock exchanges. Unless you believe that most of the players in global markets don’t know something you know, it is unwise to fight global market forces that allocate capital across the world’s financial markets (the cumulative effect of thousands of decisions to buy and sell investments made every single day around the world).

Avoiding home bias allows an investor to diversify – allowing them to take advantage of different countries’ economic cycles, technological breakthroughs, and trade relationships, that are available to businesses listed in other parts of the world.

Another key factor to consider when diversifying across different types of assets or investment choices, is liquidity – that is: how easily an investment can be cashed in if some funds are needed. Property, while historically a decent accumulator of value, is impossible to sell in small chunks, and often has quite hefty transaction costs (e.g. agents, legal bills) and tax implications. Even large pooled investments into property can suffer from significant issues if too many investors want their money back at the same time. Investment in private businesses, and unregulated investments, while potentially exciting, have similar liquidity constraints because there are much more limited opportunities for sale and trading of shares.

By contrast, government and corporate bonds (with a decent credit rating) and equities (of publicly traded companies), are sold on very large scale in tightly regulated markets, making them easy to buy and sell quickly (typically within days rather than weeks). Investment portfolios made up of equities and bonds therefore have the advantage of being able to be sold off in small slices, which can allow careful tax-planning, as well as regular adjustments in strategy or consideration of market conditions (although consistently timing markets is not possible to do and if anyone promises you they can do this, either they’re lying or they’re a fool).

Within equities, diversification not only by geography, but also company type or sector, is also very important to managing risk exposure. By investing across a diverse range of businesses, the specific risks of particular sectors (for example consumer goods / mining and minerals / healthcare) may be reduced. Although this very often means that you must accept a lower return than would have been possible if you’d focused only on one sector or a small handful of companies, the unpredictability of markets means that narrowing down your choices is inherently much more risky (and for taking more risk, you should expect more reward, but also a much bumpier ride). Once it was Kodak or Enron, today the question is which of the world’s largest companies won’t be here in 10 years time? Without time travel, or luck, the sensible answer is to spread your risks.

Hold on a moment though! Complexity is not necessarily a sign of diversity in underlying investments. A portfolio with 20 different funds in it may not be any more diverse than a much smaller number of funds with the same or an even wider range of underlying holdings. This is where the detailed fact sheets of an investment proposal can be very useful to look in a clear-eyed way at the asset mix, geographic, sectoral and other allocations made within a portfolio you may be considering.

Our investment philosophy has diversification of investments as a cornerstone of portfolio construction. We love talking about this sort of thing, so next time James at the golf course, or Dave at the pub says he’s got a hot investment tip, come and have a chat and we’ll be happy to help you think through what a strategic investment approach should look like.

NOTE: Investments can go down as well as up in value, and you may get back less than your original investment. None of the above is financial or investment advice and you should speak to me or someone else professionally qualified to give you advice specifically tailored to your circumstances.