We're into a new year, but we're still looking at financial planning, because it's a huge and important topic. In the next four posts, we're going to be looking in detail at diversification, and how to take it to the next level.
Introduction
We all know that diversification is a good thing when it comes to investing and wealth-building, but is there a limit to how useful it can be? Can you be TOO diversified?
Diversification is simply the process of adding in multiple approaches to whatever you’re trying to achieve, so that you’re not dependent on just one thing. You hear it with farmers diversifying away from dairy or beef and into glamping, or farm shops.
When it comes to investing, we talk about diversifying into different kinds of asset classes so that if one goes down, the others will go some way to help prop things up. This much you know, so how do we take it further for those of us in the Planning with Purpose stage? Actually, the question is – do we need to take it further?
Everything You Need to KNOW
1. What is Diversification for?
The classic analogy of diversification is eggs in baskets and how you should have multiple baskets in which to carry your precious and easily-broken eggs. In financial terms this usually means spreading your money around into different kinds of assets.
Or, into different funds with different providers; into different bank accounts to stay within the FSCS limits; into different kinds of wrappers so you’re not dependent on one kind of tax regime.
The purpose of all this is primarily to reduce risk. By holding different kinds of assets, when one is declining, the theory at least is that other, non-correlated assets will hold up to smooth the returns a little.
In a volatile world, diversification between providers is also, generally speaking a good idea. I remember parting ways with a client years ago who wanted to put all his money with the infallible Neil Woodford and I wouldn’t let him. I sacked him as a client because it makes no sense to pay an adviser and then not take his advice!
So, you consider risk reduction to minimise portfolio volatility, to reduce the likelihood of adverse impact due to provider failure – these are legitimate reasons to consider diversifying your portfolio.
2. It is Possible to be too Diversified
Yes, it is possible to spread your money too thinly. How might this manifest? People end up with multiple accounts with small amounts in each, multiplying paperwork unnecessarily. There’s no benefit to this at all, particularly if you have nowhere near the FSCS limit in each account.
Sometimes, this is just because people have tried different funds that have caught their eye, with no cohesive approach to doing so, but often it’s with the intention of ‘benefitting’ from diversification.
My favourite of these was explained to me by a financial adviser I knew, who has now mercifully retired. I remember him explaining in great depth to me why the fact that he had recommended five different property funds within his client’s investment bond was diversification at work – madness!
Like all aspects of our finances, we need to be intentional with our diversification; doing it for reasons which actively benefit our wealth-building. Also, it’s important to remember that as the numbers get bigger, diversification is less practical.
I deal with many clients who are multi-millionaires. At that level, it is very difficult to find homes for seven figures of cash within the FSCS limits. Also, maintaining a portfolio of 60 different funds with 20 different providers, all under the £85,000 FSCS threshold becomes more and more challenging. I don’t mind doing it of course, if they’re paying me to do so, but there’s a level of wealth when people stop worrying about this.
3. Diversification is as Much for Behavioural Reasons as Practical Reasons
I do think that to a large extent, diversification is as much to salve our fears than it is about the practicalities of investing. This in turn should have a positive impact on our behaviour, making us less susceptible to making bad decisions.
As the world becomes increasingly correlated, the main reason for diversifying, which is the smoothing of returns becomes arguably less likely. And as the scrutiny of institutions by the regulators continues to improve, then it is increasingly unlikely that a large bank will be allowed to fail, so how necessary is it to diversify at all?
But by diversifying, we feel like we’re doing something positive. It’s a bit like dripping a lump sum into the market. All the maths shows that you’ll be better off putting it into the market in a lump, but by dripping it in and pound-cost averaging, we feel like we’re doing something which makes sense to us. Diversifying then, is as much about behaviour and bias as it is about practical benefit.
Do you need to review the posts on leverage? Or are you ready to crack on here?
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