How do you diversify?

Hector66

I'm not an experienced investor but (now) understand that it's important to diversify. However I feel I'm struggling to achieve it - partly through lack of knowledge and partly through fear, which I know is counter-intuitive. I'd be interested in hearing how others do it, and any observations on my own attempts.

My (our) position:

• My wife and I have DB pensions which will cover our basic needs when we retire at 60. We know we are lucky. We are both currently 55. No mortgage. No dependents. 
• My wife is paying into the default fund in her employer's DC scheme - L&G PMC 2030-2035 Target Date 3. Pot size £140k. Now contributing the maximum to avoid minimum wage issues.
• We both have DIY S&S ISAs. Combined total £130k.
• We have cash savings of £275k.

We know we are holding a lot of cash and that inflation is nibbling, nay chomping, away at it. But we are likely to move house in the next 3 or 4 years and would like some wriggle room in terms of the price we are able to pay. Nonetheless we want to move more cash and future earnings to our ISAs. And this is where I am stuck. Both ISAs are invested in the same way and for the first few years they were largely in a couple of active UK equity income funds and an active corporate bond fund; I didn't know better. Last year I started to take more interest and, for good or ill, up-ended them. They are currently invested as follows:

Equity index tracker funds 

• 6% UK FTSE UK All Share
• 9% UK FTSE 250
• 29% US
• 14% Developed Europe
• 8% Emerging Markets
• 6% Japan
• 3% Pacific ex-Japan

Active funds

• 13% UK Equity Income
• 10% A couple of UK small cap funds
• 2% Minor amounts in global small cap funds

I suspect it is obvious that my fearful endeavours to balance away from the UK into global trackers is still a work in progress - I am getting there and it will continue. But I don't know whether a plan based on global equity trackers and cash is diverse enough. I hear that bond funds are loss-makers these days. I don't understand whether property funds (REITs?) are helpful for diversification. Ditto commodities funds. Do investments trusts have a place? And then gold? Might some say just have a multi-asset fund and forget about it? But does that suck me into bonds and is that just dead weight?

Crikey. What do you do? Am I all over the place?

Mindful that I may be challenged with two key question, here goes:

• What's our objective? Inflation protection. Anything beyond that is neither sought nor needed.

• What's our attitude to risk? We don't know because we haven't been properly tested. All we have to go on is that we sold nothing during the 2020 crash and did nothing when there was a blip at the end of (I think it was) 2018. And we've certainly not budged over the past month. My wife has had her DC since 2004 but we have no idea how it fared during the bad times c15 years ago, nor how we would have reacted, as we were not paying attention to it - shame-facedly.

Really interested in hearing others stories about diversification, particularly if like us you have been bumbling along not quite sure what to do. And, as I said, if there are any observations about our approach, I'm braced for it.

ChilliBob

I'd question the merit of the passive funds, if I have understood you have multiple passive funds to achieve the percentages you quoted?

Whilst I appreciate it may sound a rude way to put it, by doing this rather than taking a global tracker, you are on effect saying you know more than the market by choosing different weights!

So, is simplify by choosing a global tracker, avoids having to rebalanced too. 

Active funds, your call really, its quite a heavy UK allocation, but hey, commentators are saying the UK is good value compared to US and Europe so perhaps its a good call you'll only know when it's too late lol. I think people tend to avoid income funds specifically as they tend to sacrafice performance for income, perhaps better to just focus on return and sell some units when cash is required. 

I suppose the issue is diversification from more than equities..so bonds, gold, other metals, property etc. I'm personally pretty light on this myself so perhaps not best placed to comment! 

The cheapest way to do it is eith a semi passive fund of funds, something like Blackrock MyMap or Vanguard Life Strategy, the latter has a UK bias, which your active pics already give you.

There is of course active multi asset, like say Royal London Sustainable World, but hey, I put some cash in this not long ago and it's ranked 14% since!

Unless you're really into it I think maintaining your own weights to say gold, reits/property, bonds (with different durations) is likely to be very time consuming and error prone. 

TL DR: Global tracker to diversify equities, if you want further diversification away from them choose passive multi asset in a ratio of equity:other stuff that suits. Ring fence a % for the active gambles if you still want to. I know the literature tells us that passive is the way, but I can't help a tinker every now and then (and yes, I'd be better off being 100% passive!) 

Albermarle

I do not know the exact make up of the L&G fund and as it is a target fund it is presumably shifting as the target date gets closer . Lets just say for sake of argument it is 50% equity and 50% bonds .So currently you are approx 37% equity , 13% bonds and 50% cash . Could be a good strategy but you/we will only know that with hindsight. I am no expert but I would say you are probably a bit light on equity ( considering your risk tolerance seems not too low ) and as you mention I would probably diversify a little away from these main asset classes. You can look at property funds or investment trusts, infrastructure funds/IT's and maybe gold/precious metals . It is only an opinion and others will have different ones.

If you keep adding to Isa's and pension , but spend some of the cash on property , then the asset allocation will change , so you need to keep an eye on it. 

Hector66

Many thanks for replying. ChilliBob's observation that we are too heavy on UK equity and Albermarle's comment that we are too light on equity overall (hence heavy on cash) reflects accurately how I feel. For a cautious saver and investor like me, the UK and cash can easily feel the safest place to be but I know I need to overcome that flawed bias, and it is this which is driving my attempts to understand how best to diversify.  Anyway, thanks for taking the time to reply. Appreciated.   

intgomo

You mention that you have enough cover for your basic needs in retirement with the DB pensions. This could mean that you can afford to be more more speculative with the other investments. Whether you go all in on equities or mix these with (e.g.) bonds & gilts (arguably less erosive than cash in the current climate) is, as you observe, down to your risk appetite. Also, the problem with hedging using the likes of commodities (e.g. gold) is then deciding when to rebalance those hedges. Are you confident you can time the market such that you get more wins than losses or would you just stick to your desired asset allocation and rebalance annually? How do you determine which approach is best without waiting for the value of hindsight?

For what it's worth, I am in a similar position, albeit hoping to retire a bit earlier than you. Like you, DB pensions will cover basic needs for partner and I and we are slowly consolidating other investments into a global tracker (HSBC FTSE All-World in our case). In recent years, I've been convinced that I simply cannot beat the market through active investing and again, like you, simply want to keep abreast of inflation as a minimum. I'm sure we will keep a small pot for dabbling - no more than 5% of total - but this will be pure speculation.

As for cash, we have around 20% at the moment, aiming for circa 10% at retirement, which we hope will be enough to cover the big one-off expenses should the equity portfolio be languishing.

Not sure if this helps at all but I found that planning out my financial assumptions over the rest of my working life and then profiling expected drawdown needs in retirement really helped to focus my mind on what investments were appropriate for my (our) needs. There are many online tools for this (e.g. Guiide, Voyant, cFIREsim) but I chose to do it all in Excel and would be happy to share my template if you're interested.

bostonerimus

I also have DB plans that cover most of my needs and this is how I've diversified.

I treat my DB and state pensions as the fixed income part of my portfolio and invest the rest in a domestic total market index equity fund, a global market index equity fund and a small amount in an actively managed income fund which has a high bond percentage. I keep a two year cash "buffer" in the bank and I also have a 30 year old deferred annuity that is growing at 4% per year.

My other diversifier is a rental property that provides current income and capital growth.

I think you are doing well and don't need to do much other than rationalizing your funds. I would reduce the passives to a global tracker and maybe a UK tracker. 

masonic

I don't think the allocations look bad, but agree with others that some simplification could be done. A few observations are that all of your small cap exposure is UK, the US underweight could be deliberate, and if so there is at least one multi-asset funds that would allow you to preserve that if you were to remove the regional trackers. At the low risk end, you could consider funds with a specific capital preservation mandate, the most popular examples include Capital Gearing and Personal Assets Trusts, these hold about 40% equities and are currently loaded up on global inflation linked bonds. Gold, in small measure, has been used to reduce volatility and allow a higher % equities to be tolerated, thus avoiding holding more bonds than necessary. Gold doesn't look particularly cheap at the moment based on long term price trends, but might be considered an acceptable price to pay for it as a diversifier. There's little evidence for commodities as a diversifier, but property securities can be of use, though they are not low risk.

It's hard to combine these assets to end up with something with the risk-dampening properties of bonds, which having fallen significantly are better value that they have been in the recent past. Expected interest rate rises will now be priced in, so further falls would be a result of the inflation situation getting worse than it already is. Cash is not looking like a good place to be, because the first few rate rises are likely to do little to savings rates.

Hector66

Intgomo - Many thanks for the nudge that this is about what we need or intend to spend our investments on in retirement, not just about where to invest. I can see that both need to be considered but think I've lost focus on the former. If you have a template that might help me with that then, yes, I'd be most grateful. 

Bostonerimus - You have helped the penny drop for me, when you said you treat your DB as the fixed income part of your portfolio. I've not been thinking in that holistic way. I guess my DB therefore provides a fair degree of ready-made diversification.  

Masonic - I'm really interested in your comment that bonds "having fallen significantly are better value than they have been in the recent past". I'd shied away from bond funds when I tried to reorganise our ISAs last year but are people now saying they are worth including again? I'll look at Capital Gearing and Personal Assets Trusts. 

bostonerimus

Hector66 said:

Intgomo - Many thanks for the nudge that this is about what we need or intend to spend our investments on in retirement, not just about where to invest. I can see that both need to be considered but think I've lost focus on the former. If you have a template that might help me with that then, yes, I'd be most grateful. 

Bostonerimus - You have helped the penny drop for me, when you said you treat your DB as the fixed income part of your portfolio. I've not been thinking in that holistic way. I guess my DB therefore provides a fair degree of ready-made diversification.  

Masonic - I'm really interested in your comment that bonds "having fallen significantly are better value than they have been in the recent past". I'd shied away from bond funds when I tried to reorganise our ISAs last year but are people now saying they are worth including again? I'll look at Capital Gearing and Personal Assets Trusts. 

Yes, you have to look at the entirety of your finances. I haven't had much in bonds for a while now as I feel that my DB pension, SP and rental income allow me to take more risk with everything else and so I can concentrate on equities. However, this makes the invested portfolio volatile...the last month has seen mine fall quite a bit, but I've actually become very sanguine about that as I don't need it for anything other than to leave to my heirs. So, even though I'm retired, I have a long term hold plan and my heirs will get whatever they get. I've stopped worrying about money, which I think is real financial independence and one of the advantages of DB pension and products like annuities. So I think you are in a great position to enjoy a relaxing retirement.

Albermarle

I'd shied away from bond funds when I tried to reorganise our ISAs last year but are people now saying they are worth including again?

Some people are saying that,  and some not .

Most workplace pensions ( which is where most people have investments . although many do not realise it ) are still heavy in bonds . On the other hand some posters on here hold none at all .

So the answer is - it depends .

ChilliBob

My only bond holdings are from very small allocations of multi asset funds, I think if I wanted to increase my bond holdings I'd probably look to something like CG Absolute Return, or a cheaper Multi Asset fund as opposed specifically a bond fund. 

What I struggle to fully understand is the likely end result of:

a. Cash + 100% equities
b. Cash (20% less than above) + 80% equities, 20% bonds

Sure b. will be less volatile, because of the dampening effect of bonds, and sure, a will have the cash eroded by inflation. But, which will have the overall better return in X years? - I don't quite know the best way to play around and get some sense of it really!

It's been something I've been mulling over for ages in my head - e.g. should I just open a decent holding in CG Absolute return (or similar, or multi asset) rather than keeping far too much in cash?