I received an email from a reader last week, asking about shares and the reader\’s concerns about the growing risk of a share market collapse due to record high stock market valuations. This reader had primarily invested in dividend focussed funds and investment trusts, rather than individual shares, thinking that these provide sufficient diversification to mitigate risk. When I asked what the top five holdings of each fund were, however, they weren\’t entirely sure; unfortunately, I happened to know the answer, as I’d carried out research recently on several of them myself.
Although many of the funds my reader had invested in had excellent track records of growing both dividends and capital, nearly all of them had invested in the same set of around 10 shares. Names such as AstraZeneca, BP, Legal and General and British American Tobacco were all present within multiple funds – hardly a truly diversified portfolio!
Spreading investment risk
As I’m not a financial advisor, I could only really point this problem out to my friend and suggest that he carry out some research to find alternative investments. Exploring opportunities in the UK’s smaller companies and AIM markets could be a good place to start. Although some consider them to be more risky investments than established blue chip companies, if the businesses possess strong balance sheets, I see no reason for them to be ignored.
Diversifying income with overseas investments is another good alternative, along with investing in commercial or residential property, which is traditionally linked in inflation, with rents rising each year to protect your income.
Finally, investing in bonds can also diversify your portfolio, although record low yields make this a less attractive option in the current market.
UK Income Funds rely on a small group of FTSE 100 and FTSE 250 companies that pay the most income in dividends. These companies are usually selected due to their past history and historically reliable growing dividend stream. By investing in a set of UK based investment trusts and funds, you’re essentially doubling up on investments in that same group of company, just in a series of different vehicles.
To escape from this, you can hold a combination of global stocks, bonds and smaller companies; keeping your criteria for income, but diversifying away from the group of companies which large UK Income Funds traditionally rely on.