How to diversify your portfolio

It’s the three D's of investing, diversification, diversification and diversification, but why, how, when and where?

Article updated: 11 October 2019 11:00am Author: Michael Baxter

We are all wise with hindsight, but none of us can predict the future. We get things wrong. We may be convinced that such and such a stock is going to grow and grow, but things don’t always pan out the way we expect. That’s why diversification is so important.

Diversification is the antidote to the argument that investing is risky, a form of gambling. Well if you put all your money in a handful of stocks that are all quite similar, it is. But if you have true diversification and take a long-term horizon, risk is reduced enormously. You can’t eliminate risk entirely, of course, but then that is true of life. Crossing the road is risky, as is putting all your money in cash. True diversification is akin to following the Highway Code when you cross the road.

But that does not simply mean invest in lots of companies. You need diversification between sectors, diversification between regions. You need non-correlated investments. And depending on the nature of how you invest, diversification over time.

Also, remember another golden rule. To go hand in hand with investing, it only truly works if you have a long-term horizon, with flexible dates for when you might want to realise an investment. Investing with a view to withdraw all your money in 12-months time is risky, very risky. Investing with a view to withdraw all your money on a specific date in say 15-years or 25-years time is risky, because that date may happen to coincide with some kind of financial crisis. But investing, over a long-time horizon, perhaps with a view to either withdraw your investments or restructure them to provide an income, on a flexible timetable — 14 to 16-years, 23 to 27-years, now that reduces risk massively.

Diversification over time

Stocks often rise and fall in tandem. If you have a lump sum and that you want to use to create an investment portfolio, then investing all that money on the same day is risky, as there is a chance there might be some kind of financial shock soon after your investment. By drip feeding your money into your portfolio over a period of a few years, you greatly reduce this risk.

Alternatively, if you invest a set amount each month, over several years, then by definition you have that diversification over time, already.

Diversification between sectors

Don’t get me wrong. There is nothing wrong with holding several investments in companies that operate in the same sector, especially if it is a sector you like. Stocks operating in the same sector don’t always move in tandem, even during extreme circumstances. Take the travel sector — since Thomas Cook went bust, shares in TUI have risen strongly. But, sticking with this sector, it’s been a tough few years. Obviously, Thomas Cook shares had fallen sharply before it went bust, but actually, shares in TUI are down by a third over the last year, and has fallen over the last five-years, as has EasyJet.

Some sectors consist of stocks that are very different. Take tech. The companies that make up this sector have contrasting business models. Apple, Microsoft and Facebook are often subject to quite different forces. Even so, market sentiment is a funny thing and tech stocks often do rise and fall in tandem.

But even if you invest in different sectors, you can still see correlated movements. Sectors, like UK travel and UK retail, for example, both rely on the UK consumer. If the UK consumer gets hit by say falling wages, a falling pound, or a credit crunch, then companies in different sectors can fall.

The same applies to property. When house prices fall, this is not only bad news for house builders, but firms that sell to UK consumers can get hit too.

So look at investing in sectors that are as un-correlated as possible. For example if you have investments in companies that are exposed to UK consumers, then also look at companies that sell into regions in which the local economies obey a different economic cycle to the UK.

For example, post 2008 crash, techs and emerging markets were among the first to recover.

Oil tends to foreshadow the economy. When it reaches exceptionally high levels, as happened in 2008, the economy often slows soon after. But post 2008, the oil price recovered quite quickly, largely thanks to demand from China. So during the depths of the 2008/09 recession, oil offered quite good diversification — although, of course, BP suffered its own problems a few years later.

Right now, one of the big threats to the economy is the danger of trade wars — in such circumstances, even stocks trading in diverse regions can be vulnerable to the same risks.

As a result, you need more than diversification across regions, you need diversification across sectors.

Although, there will be very few winners from a trade war, a case could be made for saying companies that sell to their local market may benefit.

For international diversification, investing in funds is often a safer route than trying to invest directly into companies that are based overseas. Alternatively, you can invest in companies that are listed in the UK, but do much of their trade overseas.

Actually, the FTSE 100 offers quite good diversification as a good proportion of its members do most of their trading outside of the UK.

But the FTSE 100’s big weakness is that it does not offer exposure to some of the world’s most exciting stocks, such as the US and giant Chinese techs.

Diversification is not only a good defensive strategy, but it’s a good way to benefit from opportunities too. Investing solely in the well known US techs is risky. But I would argue that to invest solely in a broad spread of FTSE100 companies means you risk missing out on having a stake in the companies that really do seem to be changing the world — to ignore such companies altogether, strikes me as just as risky as only investing in such companies.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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