Diversification and asset allocation

Diversification means putting your money into a variety of different investments rather than one or two, in order to reduce the risk of losing money¹. The logic is simple: holding a range of assets means you are never overexposed to the risks of one industry or market¹. Asset allocation is the practical side of this, the process of balancing your investments between different assets such as cash, bonds and shares².

The two ideas work together. Diversification is the principle of spreading risk; asset allocation is the decision about how much goes where. A fund does much of the work for you, because it pools your money with that of other investors to give you a stake in tens or hundreds of stocks, bonds or other investments³. This page explains how spreading money works, what the main asset types are, how to diversify with small amounts, and how pension lifestyle switching automatically changes your asset allocation as you approach retirement.

What diversification means: spreading money across different investments

Diversification is when investors put their money into a variety of assets in order to reduce the risk of losing money¹. Instead of betting everything on one company, one sector or one country, a diversified investor holds a range of investments, so that a poor result in any single holding has a limited effect on the whole.

The principle applies at several levels at once. Canada Life sets out four ways an investor can spread money: by asset class (cash, bonds, property and shares), by industry (investing across a variety of sectors such as energy, financial services and healthcare, so you are less exposed to one type of company), by region (investing in the UK and overseas so you are not limiting your investment to one country), and by investment style (a balance of funds, some focusing on growth opportunities and others on value or recovery)⁸.

Collective investment funds are the most common route to this. Investing in a collective investment fund such as an investment trust gives you access to a broad portfolio of shares, which spreads risk and minimises the impact of any one company going bust or performing badly⁴. Investment funds, sometimes called mutual funds, pool your money with that of other investors to give you a stake in tens or hundreds of stocks, bonds or other types of investments³. A single fund purchase can therefore achieve a breadth of holdings that would be expensive and time-consuming to build share by share.

The guides to investment funds, investment trusts and ETFs explain each of these vehicles in more detail, and how investing works covers the relationship between risk, return and time.

How diversification reduces risk, and the risk it cannot remove

Diversification helps lessen what is known as unsystematic risk, such as drops in the value of certain investment sectors, regions or asset types². If one sector of the market falls, a portfolio spread across many sectors, regions and asset types takes a smaller hit than one concentrated in the falling sector. This is the risk diversification is designed to reduce.

What it cannot remove is market-wide risk. When whole markets fall together, a diversified portfolio of the same assets falls too. The standard warning that accompanies every stocks and shares product makes the point plainly: the value of your investments can fall as well as rise, and you may get back less than you put in¹⁰.

The mix of assets you hold determines where you sit on this spectrum. Which? describes the two ends of it: a portfolio entirely formed of equities has the potential to achieve high returns and beat inflation, but could see sharper falls, whereas a portfolio with a greater proportion of bonds and cash will be lower risk, but leave your money vulnerable to being eroded by inflation². Neither mix is right or wrong in itself; each trades one kind of risk for another.

The Financial Conduct Authority sets a limit for one particular kind of risk. For investments in high-risk products arranged through an online platform, its rules state a good rule of thumb is not to invest more than 10% of your money in high-risk investments⁵. The guide to FCA rules on high-risk investments covers this in detail, and investment risk and your attitude to risk explains how to think about how much risk is appropriate.

Cash, bonds, property and shares: the four main asset types

The main types of assets are equities (also called stocks or shares), bonds, cash and property⁴. Each behaves differently, which is exactly why holding more than one of them spreads risk.

• Shares (equities) are part-ownership of companies. They have the highest potential returns of the four and the sharpest potential falls. The guide to what shares are explains how they work.
• Bonds are loans to companies or governments that pay interest. UK government bonds are called gilts, and the guide to bonds and corporate bonds covers the rest.
• Cash held in savings accounts is the lowest risk of the four, but its value can be eroded by inflation over time².
• Property behaves differently again, and is often held through funds rather than directly.

Pension schemes invest in a similar spread, including bonds (fixed-income investments) issued by corporations and governments, equities (shares in companies), property, infrastructure, and other alternative investments¹². The mix a scheme holds is its asset allocation, and it is one of the main reasons two pensions with the same contributions can behave very differently.

Because the four asset types respond differently to the same events, a fall in one is often accompanied by a smaller move, or none, in another. That is the mechanism by which spreading money across the four main asset types reduces risk⁸. The comparison of bonds vs equities shows the trade-offs side by side.

Diversifying with small amounts of money

Diversification is not reserved for people with large sums. Instead of investing a lump sum, you can choose to invest regularly, from as little as £50 per month¹³, and funds can be started with small amounts from around £50 a month⁴.

Funds are what make this work. The benefits they list include access to a wider range of investments than you could normally buy yourself, expert fund management, diversification, economies of scale, small minimums, access to specific markets and values-based choices⁴. A £50 monthly purchase into a fund buys a slice of a portfolio holding tens or hundreds of investments³, something that would be impossible buying individual shares at the same cost.

If you want to hold shares directly rather than through a fund, diversification is still possible, but it demands breadth. A diversified portfolio could be built from stocks alone, but you would have to invest in a wider range of stocks to make sure the portfolio is sufficiently diverse¹. Twenty holdings spread across different sectors and regions is a very different proposition from twenty holdings in the same industry.

The practical guides to setting up monthly savings into an investment account, the minimum amount you can invest and investing a lump sum vs investing monthly cover the mechanics.

Doing it yourself or using a ready-made fund

There are two broad routes to a diversified portfolio, and the choice is about time, knowledge and control rather than cost alone.

The first is to do it yourself. It is possible to build a diversified portfolio yourself, but it can take a lot of time and work, and you need a lot of knowledge and experience⁷. A self-invested personal pension (SIPP) is the most hands-on option, allowing you to choose your own specific investments from a range of thousands of shares, exchange-traded funds (ETFs) and mutual funds¹⁵. The same independence means every decision, including the diversification ones, is yours.

The second is to use a ready-made option. Bank of Scotland's Ready-Made Investments and Ready-Made Pensions are already diversified, which can help spread your risk when things get bumpy¹⁶. Similar ready-made and model portfolios exist across the industry, and the guide to ready-made funds and model portfolios from platforms explains how they work.

One structural point is worth knowing if you choose funds. Investment trusts are likely to be more volatile than equivalent funds, because of the combined effect of gearing and the discount¹⁷. The guides to investment trusts explained, what gearing means on an investment trust and active vs passive investing cover these differences.

Lifestyle switching: moving pensions to lower-risk funds before retirement

Lifestyle switching is an automatic process that gradually moves pension savings from higher-risk funds, such as shares, into lower-risk funds, such as cash, as you get closer to your chosen pension date⁶. It is designed to reduce the impact of short-term falls in fund values shortly before you plan to take your pension savings⁶. Moving to a lower risk fund reduces the impact of falls in the stock market close to your chosen pension date⁶.

The rules for stakeholder pensions, set out in official guidance, describe the same mechanism: lifestyling means that at least five years before retirement your pension savings will start to be moved into less risky investments, and this can be turned off before it begins¹⁸. Some workplace pension schemes gradually move your money into lower-risk investments as you get nearer retirement age¹⁹, and as you get near to the retirement age for your pension, you can ask your pension provider to gradually move your money to investments with less chance of reducing in value in the short term; some schemes do this automatically²⁰.

On one example plan, the process works month by month: each month units are automatically switched, without charge, from medium or high risk funds into a lower risk fund, and this continues so that after five years all the pension savings are invested in lower risk funds⁶.

How lifestyle switching moves a pension on one example plan.

The starting point varies between providers. Lifestyle switching usually starts five years before your chosen pension date, although some plans switch savings at a different time or move them in one go⁶. Among master trusts, The People's Pension automatically starts switching from higher-risk investments into lower-risk investments from 15 years before your chosen retirement date, while Now: Pensions starts 10 years before your planned retirement age, moving savings into investments designed to prepare your money for retirement, including reducing investment risk²¹. Most pension providers will shift you into lower-risk investments such as bonds, in a process known as lifestyling, as you approach retirement¹⁵.

The timing matters because of when you can access the money. The earliest you can usually move your pension into drawdown is age 55, rising to 57 from April 2028, unless you are retiring early due to poor health or have a provider's earlier protected age²². As you approach your retirement age, your pension pot is invested into lower-risk assets, with lower returns, to protect your retirement savings from sudden market changes²³. The guide to pensions covers the wider picture.

Where lifestyle switching can work against you

Lifestyle switching targets your chosen pension date. If you access your pension savings before or after that date, there is the possibility of funds not being switched at the right time⁶. Someone who retires earlier than planned could find their savings still largely in higher-risk funds at the moment they come to take them; someone who retires later could spend years in lower-risk funds, with lower returns, while not needing that protection yet.

The choice is not always locked in. On Phoenix plans, lifestyle switching continues unless you ask for it to be turned off, and a saver who has never had it can ask for it to be turned on²⁴. Your pension plan may also offer the option under a different name: phased, protective, automatic or default switching²⁴. Not all pension plans offer the option at all⁶.

If lifestyle switching applies to your plan, you can normally choose where your pension savings and any future payments are invested⁶. To find out whether the option is available, contact your provider, or check your annual statement, as some pension plans include this information there⁶. Savers who want more control can take a more hands-on approach: one case study describes a saver who reviewed her investment choices and will move part of her pension savings into a lower risk fund a year in advance of whenever she plans to access them²⁴.

Two further points of flexibility are worth knowing. Stakeholder pension rules allow you to switch to a different pension provider without penalty charges²⁵, which matters if your current plan's lifestyling does not suit your plans. And the date you tell your provider matters: keeping your chosen retirement age up to date is part of making the switching work as intended, since the whole process is timed against it⁶. The guide to what happens if a pension provider fails covers protection separately.

Diversification does not guarantee against losses

Diversification reduces risk; it does not remove it. Even a well-spread portfolio can fall in value, and although diversification aims to lessen the impact of any one holding performing badly, there is no guarantee this will always happen⁷.

The extreme end of the risk is stated plainly in investment guidance: in extreme circumstances you could even lose all your money²⁶. That is not a warning about exotic products alone; it is the logical limit of market-wide risk, the risk that diversification within a market cannot touch. It is natural to want to know exactly what the risks are before investing¹¹.

The same applies to income drawn from investments in retirement. With pension drawdown, the value of your pot could take a hit if your investments underperform²⁷. A pot that was diversified on the day you retired can still be damaged by a market fall in the years after, which is one reason the timing of lifestyle switching matters so much.

Where to go for help depends on the question. MoneyHelper style free guidance and the Pension Wise service cover retirement choices; the guide to how much a financial adviser costs covers paid advice; and the Financial Ombudsman Service handles complaints about how a product was sold or run.