‘Diversification’ is the kind of word that you’ll probably only ever hear about in finance. But it’s a simple concept to learn and crucial to your long-term investment success.
In essence, it’s about having a bit of everything.
Imagine taking part in an office sweepstake for the World Cup and getting Germany, Brazil, Italy, Argentina, France, Spain, England and maybe the United States, Netherlands, South Korea, Uruguay, China, Ghana, Japan, Croatia, Colombia, Sweden, Mexico, Australia, Norway, Morocco and Portugal too.
It’s a bit like that.
Diversified by investing through funds
Being properly diversified as an investor can take many forms. At its simplest, it can be about investing in funds rather than a few individual shares or bonds.
Rather than investing in this or that bank or technology company, for example, you’re invested in a fund comprising all the companies in the FTSE All-Share Index. In just one hit, you’re invested in the shares of almost 600 different companies, which means your risks are spread across all these companies rather than tied to the fortunes of a few.
That allows falls in some share prices to be compensated by others rising, and ensures you benefit from the performance of the broader market – in this case, the UK market.
Being diversified across global markets
But why settle there? Why just the UK market? After all, the UK economy represents just 3.2% of the global economy1 and the London Stock Exchange just over 4% of all the world’s listed companies2.
Being diversified means spreading your risks across different countries and regions too. That way, you’re not just spreading your risks across hundreds of different companies but thousands of them.
What’s more, you’re gaining exposure to different national economic and business conditions, which can help to drive relative market performance, and to different industry mixes too.
The US, for example, has a vibrant technology sector, which accounts for almost a quarter of the value of the entire market3. In the UK, IT companies account for little more than a hundredth of the overall market, which has a bigger relative share of energy and mining companies4.
Different markets can also – you guessed it – perform differently. They can shift from being the hottest ticket in town one year to being given the cold shoulder the other, as the table below illustrates.
Key bond and share index returns (%), ranked by performance
Past performance is not a reliable indicator of future results.
Source: Vanguard calculations, data from 1 January 2012 to 31 December 2022, using data from Barclays Capital, Thompson Reuters, Datastream and FactSet. Global shares represented by the FTSE All World Index, North American shares by the FTSE World North America Index, emerging market shares by the FTSE All-World Emerging Index, developed Asia shares as the FTSE All World Developed Asia Pacific Index, European shares by the FTSE All World Europe ex-UK Index, UK shares by the FTSE All Share Index, UK government bonds by the Bloomberg Sterling Gilt Index, UK index-linked government bonds by the Bloomberg UK Govt Inflation-Linked UK Index, UK investment grade company bonds as Bloomberg Sterling Aggregate Non-Gilts – Corporate Index, Hedged global bonds as Bloomberg Global Aggregate Index (hedged in GBP). Performance shown is cumulative and denominated in GBP. It includes the reinvestment of all dividends and any capital gains distributions. The performance data does not take account of the commissions and costs incurred in the issue and redemption of shares. Basis of fund performance NAV to NAV.
Bottom line: it pays not to be overly concentrated in one or two sectors, in order to benefit from the potential broader market gains.
Being diversified across shares and bonds
And then there’s what we consider to be perhaps the most important form of diversification – combining shares and bonds. Also known as an investor’s ‘asset allocation’, it is something that is inextricably linked to Vanguard’s second investment principle of ‘balance’.
This is because independent research has long shown that having the right balance of shares and bonds in your portfolio can have more of an impact on your long-term investment success than anything else you do.
It’s something supported by our own research, as demonstrated by the diagram below, which shows how it can influence the spread of your returns from year to year.
How the mix of bonds and share defines the spectrum of returns
Past performance is not a reliable indicator of future results.
Source: Vanguard.
Notes: Reflects the maximum and minimum calendar year returns, along with the average annualised return, from 1901-2022, for various share and bond allocations, rebalanced annually. Shares are represented by the DMS UK Equity Total Return Index from 1901 to 1969; thereafter, equities are represented by the MSCI UK. Bond returns are represented by the DMS UK Bond Total Return Index from 1901 – 1985; the FTSE UK Government Index from Jan 1986 – Dec 2000 and the Bloomberg Barclays Sterling Aggregate thereafter. Returns are in sterling, with income reinvested, to 31 December 2022.
Spreading your investments across global shares and bonds can help to smooth out your returns. This is because they have historically behaved differently to each other, with shares tending to perform better than bonds in the long run but also tending to be more susceptible to greater price fluctuations and potential losses in the short run, and bonds acting as a counterweight to help smooth out returns.
This is illustrated by the performance below in white of the LifeStrategy 60% Equity Fund, which has a 60% allocation to shares and 40% allocation to bonds.
Past performance is not a reliable indicator of future results.
Source: Vanguard calculations, data from 1 January 2012 to 31 December 2022, using data from Barclays Capital, Thompson Reuters, Datastream and FactSet. Global shares represented by the FTSE All World Index, North American shares by the FTSE World North America Index, emerging market shares by the FTSE All-World Emerging Index, developed Asia shares as the FTSE All World Developed Asia Pacific Index, European shares by the FTSE All World Europe ex-UK Index, UK shares by the FTSE All Share Index, UK government bonds by the Bloomberg Sterling Gilt Index, UK index-linked government bonds by the Bloomberg UK Govt Inflation-Linked UK Index, UK investment grade company bonds as Bloomberg Sterling Aggregate Non-Gilts – Corporate Index, Hedged global bonds as Bloomberg Global Aggregate Index (hedged in GBP). Performance shown is cumulative and denominated in GBP. It includes the reinvestment of all dividends and any capital gains distributions. The performance data does not take account of the commissions and costs incurred in the issue and redemption of shares. Basis of fund performance NAV to NAV.
That’s why Vanguard’s LifeStrategy funds employ a strategic approach to this mix of shares and bonds. All you need do is choose the mix that best fits your own goals and matches your appetite for risk.
Failing that, leave it to our experts to do this for you through our Managed ISA.
1 Based on World Bank GDP data in current US$ terms, 2021.
2 Based on the composition of the FTSE All-World Index as at 31 April 2023.
3 As per the Standard and Poor’s Total Market Index as at 31 April 2023.
4 Based on the composition of the FTSE All-World Index as at 31 April 2023.
5 A study by Brinson Hood and Beebower, published in 1986, looked at returns for 91 US pension funds from 1974 to 1983 and found that roughly 80% of the variance of returns came from their strategic asset allocation. Since then, many other studies have come to similar conclusions, including Vanguard’s own research.
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