Diversification could boost your investment returns… or it could damage them!

stock market chart

When faced with the idea of investing all their long-term savings in shares, most people would probably react in horror. A stock market crash would wipe you out, wouldn’t it?

That thinking has created the profitable business of asset allocation — profitable to those who manage investments, that is. This amount in shares, so much in gilts, another portion in company bonds… you know the idea.

Set against that we have the Barclays equity-gilt study, which shows that shares have been the best performing investment from 1899 to 2016, beating cash in a savings account in 91% of all rolling 10-year periods. Extended to 18-year periods, shares have won 99% of the time. And over 23-year periods, cash has never beaten shares.

If you have an investing horizon of 20 years or more, you’ve almost certainly got more to lose from inferior performance and management fees by diversifying into all sorts of other investments, than if you stick with shares.

A mixed bag of funds?

Having decided on the stock market, many folk then turn to managed funds and start fretting over diversifying those. How much should I put into UK income? Emerging markets? Small-cap growth? There are funds of funds, which do the diversification into different individual funds for you… but that just adds another level of management charges.

I’d say all that diversifying into different funds achieves is the increasing likelihood that you won’t even match a FTSE 100 index tracker. In fact, there are very few investment managers who can beat the FTSE in the long term — I can think of Warren Buffett and our very own Neil Woodford, but then I’m scratching my head.

If you really want a fund, I’d say go for an index tracker and forget fund diversification.

Individual shares

When we choose and buy our own shares, using a low-cost execution-only broker, we’re finally coming to a stage when diversification does make sense. But even then, it still comes with qualifications.

I certainly wouldn’t put all my money into one stock, because even with those that look safe we can hit a catastrophe that sends them crashing. So spreading your investments across different sectors can definitely help — if only, say, 5% or 10% of your portfolio had been in banking shares, the financial crisis would still have hurt, but relatively lightly.

A well-diversified portfolio can be put together from just our top FTSE 100 shares. A big oil company like BP or Royal Dutch Shell, one of the major banks, GlaxoSmithKline or AstraZeneca from the pharmaceuticals sector, utilities provider National Grid, consumer goods giant Unilever… and you already have the makings of a well-diversified portfolio (without paying anyone a penny to do it for you).

Different methods

Another approach is to diversify by strategy, for example, holding a number of safe dividend-paying shares and then putting some of your money into riskier (but potentially more rewarding) growth candidates.

Or spread your money by market capitalisation, with some invested in very large companies and some in smaller cap firms.

The choice of strategy is yours alone, but there’s one rule that I always stick to. I will only ever invest in a share that I genuinely think is a great investment. If I wouldn’t buy on its standalone merits, I’d never buy a share just to diversify — that’s di-worse-ification

The best way to wealth?

Investing in shares really can help you reach one key goal as early as possible. It’s Financial Independence, an essential achievement for those who want to Retire Early.

And it really can be done, as The Foolish Guide To Financial Independence explains. Looking at ways to reduce your outgoings while building your cash, and giving you a few ideas for great investments, this brand new report is a must-read for any aspiring young retiree.

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More reading

Alan Oscroft has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended GlaxoSmithKline and Unilever. The Motley Fool UK has recommended AstraZeneca, Barclays, BP, and Royal Dutch Shell. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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