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Why diversification matters for income generation

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How to use multi-asset portfolios for income generation

Why diversification matters for income generation

Diversification has been a buzz-word in investment circles for decades.

The reason diversification is always being talked about is because all too often people are not listening: portfolios are heavily skewed towards one fund or asset class, or maintain a huge home bias instead of having a geographical spread.

And, in essence, the principles of diversification are relatively simple.

Bob Szechenyi, investment director for Rathbones, explains: "Generally speaking, it boils down to not putting all your eggs in one basket and not concentrating your risk.

"‘Income’ is an important part of meeting life goals such as school fees or retirement, which is why we want to make sure it is long-term and sustainable, and from a diversified source, with differing geographical and/or currency exposures."

He says this can help during times of market distress, when it is important that all assets are working for you but in different directions.

Why diversify?

It seems simple enough - so why should this mantra be one that is repeated often? And why should it matter in an income portfolio?

Patrick Norwood, insight analyst for Defaqto, comments: "Diversification is, of course, important in any portfolio. 

"All the various potential asset classes tend to do well and badly at different times in the investment cycle, therefore having the portfolio spread across several asset classes will smooth its volatility while still maintaining a decent return."

But when it comes to income, Joe Roxborough, chartered financial planner for Ascot Lloyd, says it is "even more important".

He explains: "When using a portfolio to provide an income, your investments need to provide [clients] with a steady stream of returns, rather than big ups and downs, which is precisely what diversification seeks to achieve."

And yet if investors only hold a "safe as houses blue chip that reliably pays out steady dividends", Mr Roxborough says this is setting the portfolio up for a big fall. What if the company "has hidden pension deficits, or behind-the-scenes management issues that could cause huge issues soon?"

There is no point chasing income from just a handful of stocks, no matter how big and bold and beautiful the dividends. 

Nor is it enough to focus purely on government bonds (especially with yields so low across all durations), or even fixed income stocks - the risks of over-relying on steady income-earners are just too great.

True diversification

Tim Morris, IFA for Russell & Co Financial Advisers, says it is "critical" to have diversification within an income-generating portfolio, especially if someone is seeking to live off the income and make regular withdrawals as a result.