Diversification is a widely accepted principle in the investment world that all investment professionals take very seriously.
However, academic studies on retail investor portfolios have long concluded that retail investors don’t diversify enough. The principles of diversification reach much further than just investing in more than one asset. In this article, we’ll explain how the diversification process could occur at all levels of your investment portfolio & decision-making process.
Diversifying across wealth managers & advisers
A wealth manager takes responsibility for designing the financial plan of a client, and in greater detail; may manage the portfolio over the investment period. This could include periodic reviews and ad-hoc discussions in reaction to life’s many surprises.
Investors could consider whether they should place their entire wealth with a single wealth manager, or leverage the different experiences of different wealth managers.
A recent trend is for the super-rich to employ a team of dedicated wealth managers to look after their money – this is known as establishing a ‘family office’. For most retail investors, a wealth manager is their financial adviser who looks after their portfolio.
However, there is little stopping you from dividing your money into two pots and giving each to a different wealth manager to invest if you feel that you don’t want to place all decision making into a single organisation. Different wealth managers will favour different investment styles and risk management techniques, therefore by partnering with more than one, you may benefit from a more generalised approach across your total net worth.
Diversifying across stockbrokers
Stockbrokers are financial firms that execute your trades (usually via a public stock exchange) and administer the settlement of those transactions.
There are over 80 regulated stockbrokers in the UK to choose from and many have been operating for more than twenty years.
Your wealth manager may have an arrangement with one or more stockbrokers to execute your trades at discounted rates, so it’s worth taking their advice on which investment platform to use, if the choice is left in your hands.
The financial regulator has designed rules that mean if your stockbroker went bust, you shouldn’t lose out financially. That’s because client assets belong to clients and are usually ‘ringfenced’ from the rest of the stock brokerage business. In practice, they can be simply transferred to another stockbroker. However, in some cases, the clients of a failed brokerage have needed to contribute towards the fees of an administrator.
For this reason, it is worth spreading your portfolio across more than one stockbroker if your portfolio begins to become substantial (£250,000). This decision is about balancing the reduction in risk against the inconvenience of using two accounts to invest in the stock market.
Diversifying across asset classes
One of the most powerful determinants of portfolio risk is not the individual selection of companies or bonds, but how you allocate your total portfolio between equities and bonds in total.
Examples of asset classes include equities (shares), bonds, cash savings, property investments and commodities.
The most common asset classes found in the portfolios of clients who are professionally advised are equities and bonds. Used in different combinations (known as a ‘weighting), these two asset classes can produce portfolios with different characteristics that match the risk profile and investment objectives of the client.
Diversifying across individual investments
This final element of diversification is the application that most investors think of when they dwell on the concept of not putting all of their eggs in one basket.
Looking at the average volatility in the price of a single share, compared to the volatility of the entire stock market, makes the benefit of this approach abundantly clear.
While a single share may fluctuate in value by up to 30% in a single day, the entire stock market (as measured by indexes such as the FTSE 100 or S&P 500) rarely exceeds a 4% daily movement.
Experts recommend that over 20 individual shares are held to benefit from asset-level diversification. Most index funds or actively managed funds meet this requirement.
