First we need to ask, what is an investment portfolio? It’s a collection of investments — such as stocks or bonds, exchange—traded funds (ETFs) or commodities — which you or your investment manager have selected after careful research. To be successful in the long term, an investment portfolio needs to be well diversified. This means not relying on any one type of asset, but holding a mix of higher and low risk investments.
Why diversify? The benefits should be obvious in your portfolio as soon as markets get a little choppy. Here’s why:
Variety is the spice of life
Diversification is about more than just, say, buying shares in a handful of companies instead of just one, although this is a good idea. Real investment diversification means investing across all asset classes — shares, bonds, property, alternatives such as commodities, and even cash. Geographical diversity is also very important, meaning you should own not just your home market, as many novice investors do, but you should think globally. Holding emerging markets, for example, may offer higher growth prospects than well developed markets, but this does come with more risk, so be sure it fits with your risk tolerance.
At the company level, you could consider investing across the market cap spectrum, from micro-cap stocks to mid caps to blue chip mega caps, and choosing stocks and bonds from different sectors and industries. Some stocks are categorised as defensive, meaning they tend to hold up well when there’s an economic downturn. This is because they’re not so exposed to declining consumer spending, or they’re deemed to be providers of essential services (pharmaceuticals and utilities for example). Other stocks are categorised as cyclical because they’re exposed to economic cycles. They tend to do well when economies are expanding, but worse in periods of economic contraction. Retailers and housebuilders are an example of this.
Diversification does not remove investing risk, but it can help you manage it better. For example, if you own ten different stocks from companies all operating in different industries, the chances are that their share price performance is not correlated, meaning shares will not move in the same direction at the same time. This means that if one of your shares falls, the overall return of your portfolio will not suffer too much, because that struggling stock only counts for one-tenth of your overall exposure. Or imagine if you had two retail stocks, but you had diversified geographically — your UK supermarket might underperform as consumer confidence falls post—Brexit, but your luxury brand selling into China might perform exceptionally well, as higher middle class incomes boost demand for designer handbags.
Good diversification has been proven to help investors avoid the worst of financial market ups and downs. With enough variety in your portfolio, you will usually own some investments that are in favour, even if some others are doing badly. The things that are doing well help cushion the blow of those that are falling. Research from Fidelity looked at the average, best, and worst annual returns of portfolios with different risk levels over an 89—year period. It found that the most aggressive portfolio, made up of 70% domestic and 30% international stocks, had an average annual return of 10%. Its best one-year return was 163%, while in its worst year it would have lost 68% — big swings which would feel too uncomfortable for many investors. But it also found that broadening the asset allocation slightly made the highs and lows less dramatic without giving up too much long-term performance.
A better risk/reward balance
Investing successfully means choosing investments that are appropriate to your level of risk tolerance, and this will change over the course of your life. When you are young, you have a long investment time horizon, meaning your money has time to grow in higher risk areas of the market, and any periods where your investments fall don’t matter as much in the context of the bigger picture. When you get older and closer to retirement, you have less time to recoup any losses, so you may want to focus more on preserving your capital by holding more conservative assets. Diversification is important in investing because it’s a way to balance risk and reward more effectively in your portfolio. You can do it gradually by pruning your positions, rather than overhauling your whole portfolio at once, which would expose you to greater market risk.
Over-diversifying can be as bad as putting all your eggs in one basket. You can worsen your portfolio’s risk/reward potential by adding too many investments which serve the same purpose, are correlated to each other, or are simply poor quality holdings added in just for the sake of diversification. If you have a 100—stock portfolio, you might be better just buying a cheap index tracker ETF to get the same effect for less money.
For more on this topic, read this article on the power of diversification.