Whenever you meet with a financial planner you can expect to be told that you should diversify your investments to reduce risk. But how much diversification should you accept and when does it cease to become a good thing?
First, and from the outset, I am a fan of diversification. It does help reduce risk in all sorts of ways. Whether it is diversification of assets across cash, bonds, property and equities, or across fund managers, investment strategies or currencies – risk is reduced. However, to play devil’s advocate, reduced risk also means reduced potential returns and reduced potential for beating the market.
No one fund will provide you with complete diversification as you will still be subject to the preferences and bias of a fund manager or the company employing the fund manager. The way to reduce this ‘manager’ or ‘house’ risk is to invest in more than one fund. Even funds with the same investment objective can have very different results but you do have to be careful…
If two or more funds are investing in the same areas such as the FTSE-100 or S&P 500 they might often have similar holdings. So by investing in different funds you may not be diversifying your investments by as much as you think and where these funds just track the index returns very similar.
Some funds invest in other funds. These are known as fund of funds. These are super-diversifiers investing in 20 or more underlying funds which are usually accessed on favourable terms. If you have a relatively small amount to invest and you are concerned about diversification, a fund of funds approach may be the answer.
These funds are generally offered in various currencies and are managed within pre-defined risk parameters. Whilst the annual management charges are generally more expensive than buying an individual fund; professional portfolio management, fund research and reduced risk are advantages not provided by individual funds.
So how much diversification is enough? The answer to this question will depend on your thoughts on risk; the amount being invested and what your investment objectives are. An investment professional should discuss these important points with you to ensure that he or she has a good understanding of your needs before making any recommendations.
I hope you found the above useful. If you have any questions please contact me.