Costly investor mistakes to avoid when trying to diversify your ISA

“Don’t put all your eggs in one basket” is one of the best-known rules of investing. It’s simple: if you put all your money into one investment and it fails, you’ve lost everything.

Diversification means splitting your money across a wide range of investments to spread the risk of loss. It sounds straightforward, but it’s easy to get wrong if you’re managing your ISA or SIPP yourself.

In trying to achieve diversification, investors sometimes overcomplicate their portfolios or lose sight of their financial goals. Here’s how to avoid doing that and the mistakes investors sometimes make.

Investing mistakes to avoid when trying to diversify

Inexperienced investors can easily make one of several missteps while building their portfolio.

Studies have found that investment-specific risk can be almost eliminated with a portfolio of just 15-20 randomly chosen investments. While it’s possible to reduce risk further, the diversification benefits diminish rapidly, while the costs and admin can increase.

Investors who prefer a hands-off approach often choose a global tracker fund, like the Vanguard FTSE All-World ETF. While there’s nothing wrong with this approach or fund, holding exclusively shares in large- and mid-cap companies isn’t full diversification.

Choosing three to five funds or trusts can be a good starting point, but remember that some funds are very similar.

For example, beginners often buy multiple funds tracking major indices, like the S&P 500 and the Nasdaq 100. Those two indices contain roughly 85 of the same companies; buying both trackers means you effectively invest in those companies twice, which actually reduces your diversification.

Non-correlation between your investments is a requirement for a diversified portfolio. However, if it were possible to match every holding to another with absolutely no correlation, it would be like betting on both teams in a football match. Your goal is to spread risk, not eliminate it.

Creating your own diversification

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To create a portfolio that’s both diversified and aligned with your financial goals, you’ll need to make decisions at several levels.

Different asset types (such as cash, bonds, shares or property) involve different risks. For example, cash is vulnerable to inflation, while shares are exposed to volatility. Higher volatility risk means lower inflation risk, and vice versa – so you can choose a balance that suits your goals and timelines.

Economic trends and currency exchange rates mean that the world’s stock markets move independently rather than collectively. Established markets move relatively slowly, while emerging markets can move more quickly – both up and down. You may prefer one or the other.

Investments generally involve event risk, meaning their performance can be influenced by unexpected changes, whether natural, industrial, or regulatory.

Since investments in the same sector or industry will usually be affected by the same events, it’s sensible to invest across several. It’s also reasonable to exclude certain sectors, based on performance expectations or ESG concerns.

Diversification done for you

You might not feel confident making these decisions without professional help. So, many DIY investing platforms provide fully diversified options you can select in just a few clicks. These come in a couple of different forms.

Some providers, such as Monzo and Zopa, offer multi-asset funds, with names like ‘Cautious’, ‘Balanced’, ‘Bold’ or ‘Adventurous’.

Each fund invests in a mix of lower-risk and higher-growth investments in specified proportions. They’re managed by an investment manager, who does the buying, selling, and rebalancing. You’ll pay a fee for the manager’s skill and experience.

Other providers offer ready-made portfolios containing several different funds, chosen to avoid overlap and offer exposure to specific areas. They might be aligned to different risk levels or to other priorities, such as a technology focus or ESG preference.

For example, AJ Bell offers ‘starter portfolios’ that each contain three actively managed funds and two tracker funds. Trading 212 offers ‘pies’ that contain a selection of ETFs, which keeps costs low.

Any of these approaches can be a great way to build investing experience, without accidentally taking more risk than you intended. Don’t let diversification doubts hold you back.

When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.