Diversification unpacked – what is it and how can it help your personal financial plans?

Diversification is an essential concept in personal financial planning and can make a significant difference to the long-term outcomes of an individual’s financial journey. 

But what is diversification, how does it work, and should you be thinking about more of it for your plan?

What is Diversification?

In its most narrow sense, diversification relates to investments. It is the process of selecting a mix of assets that complement each other.

This works by selecting a mix that includes different kinds of risk that balance each other out.

When investing, we pick assets that we think will grow in value over time. This is true of property, stocks, bonds, commodities such as gold, or any kind of alternatives including art, jewellery or anything else that has an inherent potential value.

The universal trouble with all of these is their value fluctuates over time. This is normal, but it can be inconvenient especially if we need to cash in on an investment at a time when its value isn’t what we hoped for or required at a particular moment.

This is why diversification within a financial portfolio is essential, in order to balance out those risks in anticipation of unforeseen circumstances.

Although the performance of any type of asset is not guaranteed, different asset classes ‘behave’ differently depending on the situation.

For instance, historically stocks have tended to perform well as economies expand and monetary conditions more relaxed whereas bonds have tended to perform well during episodes of greater uncertainty.

Although this pattern is never certain as the world changes, we can work around different risk expectations to improve outcomes where possible. Having a mixture of both can mean not losing out on growth or income when either of those is doing better than the other.

Diversification within assets

Diversification doesn’t just operate on an asset-by-asset class basis. We can add diversification within asset classes too.

The easiest to illustrate of these is within the stock market. Not all companies listed on public stock markets are the same. They all do different things with their businesses, have different earnings and future potential for growth.

Stock markets are also a global phenomenon. We can find businesses that operate and are listed around the world – be that the UK, the US, Asia or any other economy.

Selecting within these categories in order to emphasise a mixture of these characteristics is how we can diversify within this specific type of asset, whether by where it is based or by what type of product or service that company provides its customers.

Structural diversification

Diversification is often seen purely through the lens of assets and the balance of investments within a portfolio. But diversification can also be seen in terms of the structure of a portfolio too.

In practice, this means having a diverse set of financial products and vehicles such as pensions, ISAs and insurance policies, such as life insurance, in order to promote the best outcomes with the lowest possible liabilities in tax terms.

Diversifying in this way allows us to anticipate tax liabilities and potential future charges which will affect a portfolio. Pensions and ISAs are the best examples of this.

Pensions are highly valuable because of the tax relief we get for contributions. This means we have more initial capital to invest for the long term than we would with an ISA.

However, the trade-off is that pensions do accrue more tax liabilities once we begin to drawdown on that capital in retirement, whereas money within an ISA is tax-free for life. Both have their benefits, so it is worth making use of both where possible.

Do I need more diversification?

Despite having emphasised the importance of diversification, it is possible to over-diversify a portfolio. This phenomenon is known as ‘diworsification’.

Essentially, diworsification suppresses the level of risk taken to such an extent that growth of assets becomes hard – if not impossible. All financial portfolios need to take some degree of risk in order to achieve their aims, be they long-term growth or income generation.

What is important here is striking the right balance of assets. This depends on your goals, your stage of life and other key aspects of your financial plan such as dependents or changes in circumstances (such as retirement).

A financial adviser can make a real difference here in helping you to calibrate these factors in order to give your financial portfolio the best balance of risk and diversification. This in turn will give you the best opportunity possible to meet your future goals and intended outcomes.