Anyone who starts investing quickly learns the golden rule of building a successful, resilient portfolio: don’t put all your eggs in one basket.
At times of great uncertainty, the likes of which we are seeing now, it is even more crucial to have a diversified bundle of investments. That way, you are not overly exposed if one company, sector or region takes a big tumble.
But while most investors know the value of diversification in protecting their wealth, many botch it in the execution, misguidedly believing it is simply a matter of buying a bit of everything.
Badly performed diversification can quickly turn into its evil cousin, what experts playfully call ‘diworsification’ – a portfolio that unintentionally is riskier than it appears.
Gathering storm: At times of great uncertainty, the likes of which we are seeing now, it is even more crucial to have a diversified bundle of investments
So how can you avoid diworsification? Unfortunately, the only true test of whether you have a protected portfolio is to sail it through a time of stock market turbulence; storms, volatility and crashes will quickly reveal which portfolios are well constructed and which fall apart.
By then, though, it is often too late and any damage will have been done.
Yet there are some tell-tale signs of diworsification that you can look out for now – so you can repair and watertight your portfolio before facing the storms on the horizon.
1. Some investments can perform badly
Many investors misguidedly believe that a good portfolio is one in which all investments are going up. They prune out holdings that are eroding their wealth and double down on their winners.
But if all of your investments are rising in value at the same time, the chances are they will fall simultaneously as well.
It is not easy to hold on to investments that are underperforming – especially if they have not shown their worth for a number of years. But you may be grateful you did.
David Coombs is head of multi-assets at investment manager Rathbones. He says: ‘During a strong bull market, you have got to have some investments that are going down. It takes a lot of self-discipline not to sell them, but you will be really glad of them if you get a reversal in market trends.’ He adds that it can help to think of these underperforming investments in the same way as home insurance.
He explains: ‘We hate paying for insurance because it feels like throwing money away. But you’ll be grateful to have it in a crisis.’
The box at the bottom of this article on how to find assets that don’t all move together gives you help in finding investments that do not shift in lockstep.
2. Funds may be more alike than you think
Investors are told that holding a range of investment funds straddling sectors, geographies and investment styles is key to diversification.
However, you may diligently follow this strategy to the letter and still find you are overexposed to a small handful of companies.
How? Let’s say you buy three funds: a global, US and technology fund. Since they have different mandates and focuses, you may assume they are creating diversification in your portfolio.
But the chances are the top holdings for all three funds are the same: the likes of Amazon, Apple, Facebook and Google parent company Alphabet. That is because these companies are so big that they dominate not just technology, but also US and global funds.
It is not simply enough to buy a range of funds in different sectors and geographies.
Check their underlying holdings as well to make sure you are not reliant on a small number of companies.
How more shares cuts risk
This chart shows how Elton and Gruber’s Risk Reduction and Portfolio Size paper illustrated how holding more shares reduces total risk.
Among the influential work on portfolio size and risk done over the years has been that by New York finance professors Edwin J Elton and Martin J Gruber, writes Simon Lambert.
In an article published in the Journal of Business in 1977, entitled Risk Reduction and Portfolio Size, they looked at how the number of different shares in a portfolio affected risk.
Using data from a sample of 3,290 securities on the New York Stock exchange, they looked at portfolio size from one single share up to 200 different shares and compared it to an equally weighted portfolio of all securities in the population. (All the shares in the index held equally).
This variance between performance of the limited portfolios and the equally weighted portfolio of all securities in the population was used to define total risk.
Elton & Gruber: Risk Reduction and Portfolio Size (Journal of Business, 1977)
The chart and table above, using Elton and Gruber’s data, shows how total risk figure drops dramatically as more shares are added up to about ten shares and then starts to decline more slowly. A ten to 20 share portfolio represents considerably less risk than a four to six share portfolio.
The total risk score for a single security portfolio was 46.8, falling to 26.9 with just two shares, and more than four times smaller at 11 with ten shares.
Total risk fell to 7.9 with 50 shares and 7.3 with 200 shares, compared to a minimum risk figure was 7.07.
They noted: ‘While total risk does go down at a slower and slower rate as more securities are added… the decrease may still be of importance to management. For example, a 15 stock portfolio has 32 per cent more risk than a 100 stock portfolio.’
3. Beware of buying too many investments
There can be something comforting about holding a lot of different investments – especially as we enter choppy waters. But hold too many and you can quickly lose sight of your investment strategy. And it can cost you dearly. That is because the cheapest way to invest is to buy index funds that track – rather than try to beat – the stock market.
To try to outperform the stock market, investors use more expensive, active funds where fund managers hand pick the companies they think will do better than average.
But if you buy too many active funds, you are likely to end up with so many different holdings that your portfolio looks no different to a cheap index fund. The only difference is you’re still paying a premium for an actively-managed portfolio.
Nadeem Umar, at wealth platform Hargreaves Lansdown, explains: ‘You want to avoid paying for ten active UK funds that essentially give you market exposure rather than outperformance. You can get this far more cost-effectively through a single tracker fund.’
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There is a second danger to holding too many funds: you lose track of what you have got. Managing an active portfolio takes work.
You need to keep an eye on the performance of your funds, keep track of whether they are still following the strategy they promised, and ensure the funds in your portfolio are working together in the way you would like.
But not even the most diligent investor can keep a close eye on a large number of investment funds.
Adrian Lowery, analyst at investment platform Bestinvest, says: ‘There is no golden rule as to the ideal number of funds for a private investor’s portfolio, but something like ten to 20 is probably about right. It’s enough to achieve genuine diversification, but not too many to keep track of and not too much overlap.’
4. Don’t forget your home and your pension
Investors often fall into the trap of thinking about their assets in silos. However, you may have a perfectly diversified stocks and shares Isa, but still be exposed to volatile stock markets because you haven’t thought about how your Isa interacts with the rest of your wealth.
For example, many investors hold a small proportion of cash in their Isa portfolios to provide some diversification. But if you have a cash Isa alongside your investment Isa, you may find you are holding far more cash than you need to.
Lowery explains: ‘Investors should look at diversification across their whole universe of finances. Homeowners might decide, for instance, that their property – even though it is primarily a residence – provides enough exposure to the property sector not to hold property-based investments in an Isa.
‘Likewise, if they have a good cash buffer, they might question the point of funds that hold a significant amount of cash.
How to invest in assets that don’t all move together
Holsing a range of sectors, geographies, styles and asset classes is, of course, crucial. But to avoid diworsification, you need to stay on your toes.
Asset classes do not always act in the same way, so you can’t afford to be complacent, warns Paul Fidell, senior business development manager at Prudential. He says: ‘Over the past three years, the FTSE All-Share Index is highly correlated with the S&P 500 index of the biggest US companies.
‘But over one year, the correlation breaks down. So, as an investor, don’t assume that once you have built in diversification you can leave it unchanged. Keep checking, or else pick a multi-asset fund with a manager who can do this for you.’
Don’t ignore asset classes that are out of favour. Rathbones’ David Coombs says that when oil and commodity stocks were out of vogue a year ago and prices at rock bottom, he increased exposure to both. They were hard to stick with because they were out of favour for some time and not generating returns, but now they have proven their worth.
He believes that while prices have risen, it could still be worth buying more as oil and commodity prices keep increasing. Some investors like gold as a diversifier. It can sometimes rise in value when markets are falling because investors look to it as a safe haven to protect their wealth.
Coombs is a gold fan. ‘I am buying gold now as I fear there is a threat of recession in parts of Europe and the UK,’ he says. However, be aware that gold is limited as an investment because it doesn’t produce an income.
For months, investors were in love with so-called growth stocks: companies not necessarily producing profits now, but with potential to grow rapidly in the future. At the same time, steadier and more traditional companies – the banks for example – were less popular. This year, the balance has started to tilt towards them.
David Henry, investment manager at Quilter Cheviot, says: ‘When one style is in favour, investors have a tendency to act like a financial magpie and acquire all the shiny funds that are doing well. But it can leave you over exposed to one particular style all pointing in the same direction. Make sure you have a range.’
Finally, infrastructure and property investments often react differently in market cycles to other asset classes. Governments may continue to invest during a recession, which boosts infrastructure spending, while commercial property landlords can often lock in tenants with inflation-linked contracts.
These two alternative investment options – along with cash – are seen as good diversifiers. However, getting the right blend and incorporating them into your portfolio can take expertise. Some investors may be happier getting exposure to them through a multi-asset fund that has access to these types of holdings.
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