The investing question that many don’t ask

Being diversified means looking at different sectors, and different countries: London is just 3% of the global equity market.

Portrait of elderly man wearing white denim shirt and glasses looking up with hand on chin. Thoughtful senior entrepreneur, studio shot against grey background.

Image source: Getty Images

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

You could probably fill a decent-sized library with all the words that have been written about investment over the years.

Most readers of this column know the basics — even if they don’t all apply them to their investment decisions.

Price-to earnings (P/E) ratios, dividend yields, five-year or ten-year compound annual growth rates, cash flows, price-to-earnings-growth (PEG) ratios, gearing: these are the vocabulary of investment decisions.

And such metrics most definitely aren’t wrong — even if they sometimes provide investors with a greater sense of certainty than is really warranted.

You have to start somewhere, and those are undeniably numbers that matter.

Strategy, not selection

But there’s another question that also matters, and it’s one that I rarely hear being asked.

There is, I think, a reason for this. And it’s a reason that comes back to that comforting — if sometimes spurious — sense of assurance that numbers such as dividend yields and P/E ratios provide.

For the question to which I’m referring doesn’t have a number as an answer. The response comes in the form of a ‘yes’, or a ‘no’, or sometimes possibly a ‘maybe’, when asked when you’re considering buying a particular share.

Put another way, it’s a question that’s more to do with investment strategy, rather than the fundamentals of stock selection.

So what is this question, then?

Free lunch

Quite simply, it’s this:

“Will buying this share usefully increase my diversification?”

I know, I know.

I’ve written about diversification before, from time to time.

Yet huge numbers of investors aren’t adequately diversified — or even, often, really diversified at all.

Many, I know, rarely fish outside the waters of the FTSE 100 — the London stock market’s hundred largest shares. Some focus even more tightly, restricting themselves to those big consumer-facing shares with familiar names — companies such as HSBC, Tesco, Shell, GSK, Unilever, and British American Tobacco.

Diversified? Hardly. Which is a shame, because diversification can powerfully enhance returns, while reducing risk. Nobel Prize laureate Harry Markowitz, no less, famously remarked that “diversification is the only free lunch” in investing.

Stock diversification: an easy win

There are many facets to diversification — bonds, gilts, stocks, property, gold, cash: each arguably has attractions from a diversification point of view.

But there are also problems and challenges from a liquidity and practicality point of view. Even buying a small buy-to-let apartment costs a fair amount of money, for instance – you can’t buy one-tenth of an apartment, or a fraction of a house. Gold requires safe storage, and doesn’t earn an income. Cash depreciates in inflationary times. Bonds and gilts aren’t always the most accessible things for investors to get their heads around.

Restricting the consideration of diversification solely to stocks considerably simplifies matters, as well as lowering the liquidity barrier as well as making it more practical to implement.

Different sectors, different countries

And if we’re solely talking about stocks, then two areas of diversification that matter most, I think, can be summed up as sectoral diversification, and geographic diversification.

Both are straightforward. Sectoral diversification is about the sector, or industry, in which a given business operates. Geographic diversification is about broadening your investment horizons geographically — Europe, Asia, North America and so on.

Both are good. And the beauty of geographical diversification is that often it throws in sectoral diversification as a bonus. America, for instance, has technology giants — think Alphabet, owner of Google, Microsoft, Meta (owner of Facebook), Apple, and Nvidia — that are difficult to replicate with a purely UK focus.

Asia and Europe, in turn, provide their own opportunities for additional sectoral diversification.

London is just 3%

Europe makes up just 11% of the global equity market. America, 43%. Japan, 5%. Hong Kong, 4%. And the UK? Just 3%.

So a focus on a handful of shares from the FTSE 100 is a focus on a few of the largest shares in that 3%.

Which, when you think about it, isn’t really diversified at all.

So always think about asking yourself: if I buy this share, will it add an industry or sector that I don’t already hold? And if I buy this share, will it add to — or reduce — my geographic diversification?

Remember, it’s the only free lunch in investing.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Malcolm owns shares in HSBC, Tesco, Shell, GlaxoSmithKline, and Unilever. The Motley Fool UK has recommended Alphabet, Apple, British American Tobacco P.l.c., HSBC Holdings, Microsoft, Nvidia, Tesco Plc, and Unilever Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

More on Investing Articles

Elevated view over city of London skyline
Investing Articles

I’m considering shares in this FTSE 250 investment trust while it’s trading at a discount

With this FTSE 250 investment trust trading at a discount to NAV, this Fool thinks it's a bargain. Not to…

Read more »

Investing Articles

If I’d invested £1,000 in Tesla stock a decade ago, here’s what I’d have now!

While many of us debate whether Tesla stock is worth the price today, it's undeniable that the EV share has…

Read more »

Investing Articles

Here’s what Michael Burry did as the BP share price dipped!

The BP share price has fallen from its peaks once again, and infamous investor Michael Burry may have spotted an…

Read more »

Young mixed-race woman jumping for joy in a park with confetti falling around her
Investing Articles

What on earth’s going on with the Barclays share price?

The Barclays share price has skyrocketed in recent months, becoming one of the best-performing stocks on the FTSE 100 since…

Read more »

Man writing 'now' having crossed out 'later', 'tomorrow' and 'next week'
Investing Articles

Analysts say this amazing FTSE 100 stock is a takeover target!

This FTSE 100 stock's one of the worst-performing companies on the index in 2024. So why might other companies want…

Read more »

happy senior couple using a laptop in their living room to look at their financial budgets
Investing Articles

5.4% yield! 2 UK dividend shares to consider for a £1,080 passive income

I think these UK shares could provide a large and sustainable passive income. And they could be great buys today…

Read more »

Investing Articles

Here’s how investing £250 a month could bag me over £10K in passive income annually

This Fool breaks down how she would go about building a passive income stream worth over £10,000 annually to enjoy…

Read more »

Young black colleagues high-fiving each other at work
Investing Articles

I’d snap this FTSE 250 stock up in a heartbeat for juicy returns and growth!

Sumayya Mansoor explains why this FTSE 250 property stock is firmly on her radar as she looks to buy stocks…

Read more »