Investing: why you shouldn't put all your eggs in one basket
Diversification is one of the keys to successful investing but investors must walk the line between spreading their risk and spreading their investments too thin.
When investors talk about 'diversifying a portfolio' this is jargon for 'not putting all your eggs in one basket'. It is widely accepted that when investing you need to put money into a range of assets or funds that are 'uncorrelated', which means if one falls they don't all fall.
This is why some people invest not only in equities, or equity funds, but hold fixed income assets like bonds, or bond funds.
Scott Gallacher, chartered financial planner at advice firm Rowley Turton, uses the example of a shop selling ice-cream and a shop selling umbrella versus a shop selling both.
While the ice-cream shop will make substantial profits in good weather and the umbrella shop in poor weather, the one that does both will make a more steady return because it has spread its risk.
"[The shop that sells both] might never made the [large returns] the others made but they will never be caught out because they are spreading their risk," he said.
Gallacher said that while "you will never get rid of risk completely" you can minimise it.
While it is encouraged for investors to diversify, Gallacher warned that over-diversification could prove just as dangerous; where investors spread their money too thinly across a large number of investments.
"There is a thing as too much diversifications. Investors put their money in 100s of funds in the hope this will give them a diversified return but in fact they are buying a tracker (a fund that just tracks the stockmarket) because the investments overlap so much that you end up back in the middle," he said.
Gallacher recommended that investors diversified through picking a fund, or funds, where the manager invests in a range of assets such as "cautious managed, balanced or multi-asset" funds. This is a preferable to investors trying to pick specialist funds, such as one that focuses on Brazil, he said.
Gallacher added that for all assets to fall there would have to be a "financial Armageddon" so managers who invest through in uncorrelated assets through their funds are a good bet.
By narrowing their search down to one type of fund, investors do not have to become experts on every geographical and sector of funds. However, they will need to do some research to find a fund manager they are happy with.
Fund manager style
Investors may also want to diversify the fund managers they invest with dependent on their style. Gallacher said some managers have a "top-down" approach where they see value in a particular area and then find companies to invest in after. Others have a "bottom-up" approach where their investments are dictated by companies they like.
"There are top-down managers who will look at the macro picture and think that Germany, for example, is the place to be and will then look for German opportunities [to invest in]," said Gallacher.
"Some managers are bullish and some are bearish and what investors need to do is try and get a balance between styles...the portfolios may not be the best [for returns] but it will be slow and steady."
Gallacher said a good way to review performance of fund managers was to look at how their fund did in the most recent financial crisis.
"You need to look at how well a manager did in the last crash. Although it's not a guarantee they will do well it is a good indicator. Look at how much you would have lost...you need to understand the downside risk."
He added that those with "less than £10,000" to invest could get away with investing all their money in one fund, as long as the fund was diversified, but most people liked to spread their money across three or four to provide added security.
Read more:
A beginners guide to diversification
10 investing facts you probably don't know but should
