Diversification: What Does it Mean and Why Does it Matter?

Back in November 2024, we published an article asking a simple but important question: how many investment managers does a charity really need? Our analysis showed that while most charities use one or two managers, a meaningful minority still employ three or more, often in the belief that this automatically leads to better diversification. As we noted at the time, multiple managers do not necessarily mean a better-diversified portfolio, and in many cases they introduce complexity, overlap and higher costs without improving outcomes.

In this follow-on article, we explore what diversification really means, how it is typically delivered within charity portfolios, and why achieving genuine diversification has become more challenging, and more important, in recent years.

Multi-asset portfolios: what does that actually mean?

Many of the charities we work with appoint one or two investment managers to run a multi-asset portfolio. In simple terms, a multi-asset portfolio is one that invests across a range of different asset classes rather than focusing on a single asset class.

A typical multi-asset portfolio might include:

• Shares (equities) in UK and overseas companies

• Government and corporate bonds

• Cash or short-term instruments

• Property, infrastructure or other “alternative” investments

The aim is to build a portfolio that balances growth, income and capital preservation, while managing risk over the long term. Crucially, diversification is intended to be achieved within the portfolio, not by appointing multiple managers each doing broadly the same thing.

What is diversification, and why does it matter?

Diversification is the principle of spreading risk so that no single investment, market or economic outcome can dominate portfolio returns. Put simply, you do not want all your eggs in one basket.

A well-diversified portfolio should:

• Reduce the impact of any single company failure

• Avoid over-reliance on one country or region

• Balance different economic drivers (growth, inflation, interest rates)

• Behave differently in varying market conditions

Diversification is not about eliminating risk altogether, but about ensuring risks are deliberate, understood and appropriately balanced.

Diversification within an asset class: number of holdings matters

One of the most basic forms of diversification is holding enough individual investments. A portfolio with ten shares is far more exposed to company-specific risks than one with 50 or 100.

Academic research and long-term market evidence suggest that:

• The majority of company-specific risk is diversified away once you hold around 20-30 shares

• Beyond that, additional holdings provide diminishing but still meaningful benefits

However, simply holding a large number of stocks is not enough if they all behave in a similar way, which brings us to geography and sector exposure.

Diversification by country and region

Global diversification has become increasingly important, but also more misunderstood. Many portfolios that appear “global” are heavily concentrated in a small number of markets, particularly the US.

This matters because:

• Economic cycles differ by country

• Political and regulatory risks vary

• Currency movements can materially affect returns

A genuinely diversified portfolio will have exposure across multiple regions, and trustees should understand where returns and risks are really coming from, not just what the fund label says.

Diversification by asset class: equities, bonds and beyond

Traditionally, diversification has relied heavily on the relationship between equities and bonds. For decades, bonds often provided stability when equity markets fell.

However, recent history has challenged this assumption. In 2020, during the initial phase of Covid, and again in 2022, both equities and bonds experienced significant drawdowns at the same time. In those periods, the positive correlation between stocks and bonds rose sharply, reducing the protection many investors expected.

As a result, many investment managers are increasingly using alternative assets to improve diversification.

Alternatives: potential benefits and real risks

“Alternatives” is a broad term, but commonly includes:

• Property

• Infrastructure (renewables, utilities, transport assets)

• Commodities (including gold and precious metals)

• Private credit or specialist lending

• Absolute return strategies

The potential benefits include:

• Different return drivers from equities and bonds

• Potential inflation protection (important for real-return objectives)

• Lower correlation to traditional markets

However, alternatives also bring risks that trustees need to understand:

• Illiquidity (capital may be tied up for long periods)

• Valuation uncertainty (prices may not move daily)

• Complexity and higher fees

• Greater reliance on manager skill

Used thoughtfully, alternatives can enhance diversification. Used indiscriminately, they can introduce new risks without delivering the intended protection.

Multiple managers do not automatically mean better diversification

One of the key findings from our 2024 article was that charities often appoint multiple managers in pursuit of diversification but end up with overlapping portfolios instead.

For example:

• Two “balanced” managers both heavily exposed to global equities

• Multiple funds holding the same large US technology stocks

• Different managers reacting in the same way to market stress

True diversification is about what you own, not how many managers you employ. In many cases, a single well-constructed multi-asset portfolio can deliver broader diversification than several poorly coordinated mandates.

Stress testing: looking beyond today’s performance

One final, and often overlooked, aspect of diversification is stress testing. Trustees should be wary of portfolios where “everything is performing well” at the same time.

That can be a warning sign that:

• Assets share similar risk drivers

• Correlations are higher than expected

• The portfolio may struggle in a severe downturn

A genuinely diversified portfolio will often feel slightly uncomfortable in strong markets, because some assets are held for protection rather than performance. The key question is not how the portfolio behaves when markets are rising, but how it is expected to perform in different scenarios: inflation shocks, recessions, rising interest rates or market stress.

Bringing it all together

Diversification remains one of the most powerful tools available to charity trustees, but it is also one of the most misunderstood. It is not achieved by simply adding more managers, more funds or more complexity.

Instead, it requires:

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• Clear objectives and risk tolerance

• An understanding of what drives returns

• Thoughtful asset allocation

• Ongoing monitoring and stress testing

At PMCL, we work with trustees to look through portfolios, identify genuine sources of diversification, and ensure investment structures support, rather than distract from good governance. As with manager numbers, simplicity, when combined with rigour, often delivers better outcomes.