On the surface, diversification is a straightforward concept based on the principle that it’s risky to put all your eggs in one basket. But it’s very easy for a portfolio to become biased or have hidden correlations. These may lead to a portfolio with too many similar ideas, or one that is more exposed to a certain risk.
Most of the time, the portfolio will look well-diversified and may even perform as you would expect. However, in a challenging market, a lack of diversification in a portfolio exposes the portfolio’s weaknesses just when it’s needed the most.
A well-constructed portfolio is designed not just for the crisis you expect, but also for the ones you don’t. Such a portfolio is more resilient in a crisis and better positioned for any recovery. There are plenty of different approaches to building a well-diversified portfolio, but it is important to look at all angles to ensure it performs as you expect:
Setting your objectives
Before building your portfolio, it is important to set out what you are trying to achieve, how much risk you want to take, whether you need an income and how long you are invested for. These questions help establish an asset allocation model from which to build a portfolio.
Asset allocation
This is something that few investors do but it makes sense to write down which asset classes you are going to invest in and how much, as a percentage, you want to be invested in each area. Documenting this gives you something you can refer to over the years to make sure your portfolio remains on track.
Country exposure
One of the simplest ways to diversify equity exposure in a portfolio is by investing in different geographies. This is fairly easy to achieve as many equity funds are labelled by which country they have exposure to.
This approach aids diversification by exposing investors to a wider choice of companies, different sectors, and reduces the impact of political risks, such as Brexit. However, a geographical approach does have its limitations and can still mean a portfolio is not as well diversified as you may believe.
Sector exposure
As mentioned, exposure to different countries provides access to sectors that may not be well represented in your home country. For example, the UK has plenty of exposure to oil and miners but little in the way of technology. Arguably, the industry sector you are exposed to has a greater impact on investment returns than the country or region.
If you only consider the regional allocation when selecting funds, you could end up with a globally well-diversified portfolio with too much exposure to technology. It’s important to check how much exposure you have in each sector, so you can understand why your portfolio is performing and how exposed you are to different areas of the global economy.
Does your portfolio have style?
This is an area where investor bias often creeps in. There are four core styles to consider — Growth, Quality, Value and Momentum. Investors often have a strong preference for one investment style over another, usually a deeply in-built bias to an investment philosophy they might not even be aware of. Style diversification is very important. Historically, one style tends to dominate for a while at the expense of the other style, but this hasn’t lasted and the market rotates to the other style.
This is often referred to as market rotation and can result in significant falls in some share prices and big gains in others. It is important to understand how much of your portfolio is exposed to each style and the impact that might have on the performance and volatility of the portfolio. Investors shouldn’t see this as a value versus growth argument. Rather, it makes sense for even the most ardent growth investor to have some exposure to value stocks and vice versa.
Size matters
Smaller companies often get overlooked by investors, many see them as too risky and not suitable for their portfolio. However, whilst smaller companies can be more volatile, they offer the potential for higher returns. The key is having the right level of exposure to smaller companies so that you are not taking too much or too little risk. A cautious investor, for example, might have only 5 or 10% exposure to smaller companies, whilst a more adventurous person might have 30% or even 40%.
Equity income
There is often a view that equity income is only for those who need the income. This is not the case; equity income can be thought of in the same context as investment style. Equity income stocks often have different characteristics and will perform and behave differently.
It doesn’t mean that a growth investor should have half their portfolio invested in income-generating assets, but they should have some exposure to the area. Likewise, an income seeker should look to ensure the capital value of their portfolio does grow as that helps protect against inflation and can help support future income generation.
Bonds can help dampen volatility
Corporate and government bonds, also called fixed interest bonds, have historically behaved differently to equities and provide some diversification benefits. They are usually less volatile than equities so offer better capital protection in a crisis, although there are periods when equities and bonds can behave similarly. The fact they offer a fixed income also provides your portfolio with some returns when stock markets are not performing.
The role of alternatives
Once you have the core portfolio it may be time to consider diversifying to other asset classes. The main purpose of alternative assets is to provide exposure to investments that don’t rise and fall at the same time as the equity market or offer some protection so tend to perform when the stock market is falling. Gold is a popular example and can be a useful diversifier. Likewise, there are funds designed to smooth investor returns over the economic cycle, commonly called absolute return funds.
Building a well-diversified portfolio can take time and there are a lot of things to consider. However, the good news is you don’t necessarily need to do all of these things in one go. Even the best fund managers have learned from previous mistakes and made changes to how they build a portfolio, so can you.
Whichever approach you choose, you can use the tools and guides on Compare+Invest’s website to select a platform and investment style that suits you best.
Compare+Invest is a price comparison service that aims to take the hassle out of selecting an investment platform. On our website, you can enter a few short details about yourself and our tools and calculators can help you to decide which investment platform is right for you.
Photo by Natalie Rhea on Unsplash
Photo by William Warby on Unsplash
