Why is diversification so important?

Category: Investment

Building an investment portfolio requires a mixture of investment science and common sense.

The evidence suggests timing when to be in and out of markets (or sectors, or companies) is extremely difficult. It also suggests identifying a manager who can persistently beat the market is very hard to do in advance.

We, therefore, focus on long-term ‘strategic’ decisions when constructing portfolios. We look to capture broad, desirable characteristics different investment assets, such as equities and bonds, offer over the longer term.

So where does diversification come into this?

Spreading money (Diversifying) across and within various investment assets avoids the consequences of having too much invested in anything not doing well. These can be specific companies, sectors or entire markets. It also ensures you always own the rare companies who turn into behemoths. This makes sense.

Avoiding too much in the UK makes sense, given its small size (a little over 5% of global markets), sector biases and stock concentration levels. Taking small above market-weight positions to smaller companies and value stocks also makes sense for disciplined longer-term investors. Balancing the hopefully short-lived falls in equity markets, with higher-quality bonds that hold up well at these times is also sensible for most. In bonds, as with equities, being globally diversified, whilst hedging currency risk away, is a good starting point.

Why does diversification matter?

Diversification matters because nobody truly knows how companies, market sectors, and asset types will fare in the short term. Making concentrated bets on a few companies in the UK has a far higher chance of pain than a broadly diversified global portfolio of equities. Such a portfolio would hold thousands of companies across all sectors, markets and company sizes.

Principally, being well-diversified is about not losing money forever. It is also about having some, not all, of your money in whatever is driving returns at a particular moment in time. Recently, it may have been all about US technology firms, but tomorrow it will be something else entirely. Diversification means you do not need to guess what is coming next.

Inevitably there will also be parts of the portfolio that will be doing better or worse than others. That is part of successful investing. Try not to look back at recent winners. Be glad you already own tomorrow’s winners.

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