How to diversify your portfolio
Diversification is key to keeping your portfolio balance healthy – especially in periods of economic downturn. Discover what diversifying your portfolio means, how to do it and what impact it has on your risk-to-reward balance.
What is diversification?
Diversification is the practice of opening multiple positions across a range of asset classes. It aims to limit exposure to a single type of risk. The strategy is used by investors and traders to create a more balanced risk profile and maximise returns over the longer term.
The key to a successful diversification strategy is to ensure that the assets in your portfolio are not correlated to one another. This means not only diversifying among asset classes, but within each type of asset class too.
Why diversify your portfolio?
The core aim of diversification is to improve risk-adjusted returns – which is the degree of risk you have to take on in order to achieve a profit.
It does this by minimising or neutralising the effects of negatively performing positions. So, in the event of an economic downturn, when some positions start to make a loss, other areas of your portfolio retain or go up in value.
You’ll face a range of risks when you trade financial markets, which broadly fall into two categories: diversifiable and undiversifiable.
The former type of risk, as the name suggests, can be reduced through the strategy of diversification. It’s also called unsystematic risk as the exposure differs depending on the company, industry, market or country. As each investable area is unique, you can mitigate the impact of risk to your capital by investing in various assets.
The second type of risk cannot be diversified as it’s associated with every company or asset, regardless of industry, market or country. Undiversifiable risk is also known as systematic or market risk. As it is not a specific type of risk, it is difficult to identify and prevent. So, it’s just something that traders and investors have to come to terms with before they open a position.
As not all risk is diversifiable, it’s important to understand exactly how your portfolio is exposed to different risks and how you can protect yourself. For undiversifiable risk, hedging is a popular alternative strategy used to offset loss to a portfolio.
Potential drawbacks of diversification
While diversification reduces portfolio risk and offers longer-term growth potential, it can limit growth in the short term. Opening a lot of different position will incur costs, so it’s important to assess how much you can afford to give to this strategy.
You’ll also be dedicating time as well as capital, as diversification requires the regular monitoring of the health of your portfolio. Some investors choose to open fully managed portfolios, to pass over this responsibility to a professional.
Popular asset classes and instruments for diversification
While most asset classes can be used to diversify your portfolio, there are some that are continuously popular among investors and fund managers. These include:
Shares are the units of ownership in a publicly traded company. It's important to diversify across the stock market – looking at factors such as market capitalisation, sector and geography. You’ll just need to make sure that the stocks you choose are affected by a range of different factors.
A common method of share diversification is selecting some cyclical stocks and some defensive stocks. Cyclical stocks are those that rise and fall in line with economic growth, and often outperform in periods of health when investors are more optimistic. While defensive stocks retain their value regardless of the business cycle, making them a useful safety net for a diversified portfolio.
Exchange traded funds (ETFs)
Exchange traded funds (ETFs) are investment instruments that track the performance of a group of markets. ETFs are passive instruments, meaning they mirror the returns of the underlying market and will not outperform it.
ETFs can include a variety of assets, including shares, commodities, currencies and bonds.
Choosing an ETF instantly diversifies your portfolio more than most asset classes, as you’ll have a position on a number of markets. For the most part ETFs track assets from the same grouping – eg an index of one sector or country.
When determining which ETF to pick, you’ll need to research its composition, the weighting of assets and their past performance. You can do this by reading the ETF's prospectus or key investor information document (KIID) before taking a position.
Search the 6000+ ETFs available with us using our ETF screener.
Bonds are fixed-income instrument that represent an amount of debt. They are usually issued by a government or corporation, promising to pay an investor regular interest payments until the loan is repaid.
There are so many different types of bonds available that it’s an extremely effective way to diversify a portfolio. Bonds can vary in:
- Quality – the value of a bond depends on the reputability of the company or organisation that issues it, as well as the rating given by agencies such as Moodys and Fitch
- Geography – bonds that come from developing countries can provide greater growth potential than developed economies, but this is often because they have a higher risk profile
- Maturity – bonds with a longer time until the full repayment is due will often have larger interest payments, earning you more in the long term
- Duration – the sensitivity of a bond to interest rate changes can impact its ‘yield to maturity’, which is the total return anticipated
Overall, fixed-income assets are a great way to diversify your portfolio as they ensure long-term income.
Commodities can be a useful diversification asset as they often have a low correlation to the returns of equities and bonds.
Commodities usually have a different business cycle to the rest of the economy, which means they can be used as a hedge in downturns. The most common example is gold, which has been used as a safe haven for decades. However, this isn’t a hard and fast rule so it’s important to do your research into how markets have behaved in the past.
Some commodities are also seen as consumer staples – like defensive stocks – which means they are needed regardless of the state of the economy. Examples include food and energy.
The most important consideration is how to get exposure to commodities. A lot of traders and investors use futures contracts – an agreement to exchange an asset for a set price on a set date. Although there is an obligation to settle a futures contract, this can be done in cash rather than in physical delivery. So, futures can capture the market sentiment around commodity prices, without the need for taking ownership of the underlying commodity .
Another popular way to diversify portfolios with commodities is through ETFs – giving a much broader exposure to a variety of commodities – including precious metals, industrial metals, energies and agricultural produce.
Diversification and risk vs reward
Even among diversification strategies, there are higher and lower risk profiles. As an easy way to see how diversification and asset allocation impacts risk and reward, let’s look at the five categories of IG Smart Portfolios.
- Conservative. These portfolios invest in quality bonds and shorter-term investments that are fixed income. They’d suit you if you’re very risk-averse, and are looking for a steady income rather than capital growth
- Moderate. This risk-reward level is designed to protect your savings while helping you stay ahead of inflation over the longer term. It focuses on government and corporate bonds as well as global equities and alternative assets (such as gold)
- Balanced. This portfolio type – as the name suggests – is split evenly between fixed-income assets and global equities, with some alternative assets. It’s designed to help you increase you’re your savings over time, but with improved diversification
- Growth. These portfolios invest primarily in global equities, with some diversification into fixed-income and alternative assets. It would suit high-risk appetites, who are comfortable with fluctuating returns, in the name of capital growth over the longer term
- Aggressive. This risk-reward level is designed to suit investors with a longer investment horizon, who can take on a greater amount of investment risk – as there would likely be significant fluctuations in capital to achieve longer-term growth. The portfolios invest in equities with a small exposure to fixed-income assets and alternatives
Each of these portfolios will experience different returns and be impacted by volatility in different ways, as you can see by the table below:
The more risk-averse portfolios have lower ‘best’ returns but significantly lower ‘worst returns’. Meanwhile, the more high-risk portfolios outperform in periods of growth, but suffer more heavil in downturns. The balanced portfolio, which places an emphasis on diversification, sees a happy medium.
Your choice of which risk-to-reward strategy should always depend on your goals as an investor.
Calculating your risk-adjusted return
To calculate your portfolios risk-adjusted return, there are a few methods you can choose from. Two of the most popular are the Sharpe and Sortino ratios.
The Sharpe ratio
The Sharpe ratio takes the average portfolio return, subtracts the ‘risk-free rate’ (explained below) and divides the difference by the investment’s total volatility.
The risk-free rate of return is the theoretical return that an asset with fixed interest payments would make, without you taking on any risk. In practice, there’s no such thing as a risk-free investment. However, treasury bills are commonly used as a measure of a risk-free rate. To calculate your risk-free rate, you’d subtract the current inflation rate from the yield of the T-bill that has the same duration as your investment.
Removing the risk-free rate will help you see whether a riskier approach is worthwhile in comparison to different portfolios. The Sharpe ratio is a positive measurement of volatility – so, the greater the Sharpe ratio value, the more attractive the portfolio’s returns would be.
The Sortino ratio
The Sortino ratio is similar to the Sharpe ratio, but instead of considering the upside risk of a portfolio, it only considers the downside potential.
Critics of the Sharpe ratio argue that it only gives an understanding of positive volatility that brings returns, which is what investing is all about. So, by looking at the downside risk that comes with volatility, you can have a clearer picture of your risk-adjusted performance.
To calculate the Sortino ratio you’d take the difference between portfolio return and the risk-free rate and divide this by the standard deviation of the negative returns. The higher the Sortino ratio, the better – this means that the more risk you take on, the more your portfolio is earning.
Examples of diversified portfolios
To better understand how diversification impacts performance, consider how these two hypothetical portfolios would have performed in the 2008 financial crisis:
- A balanced IG Smart Portfolio – made up of 5% UK stocks, 42% foreign stocks, 44% bonds, 4% short-term investments and 5% commodities
- An all-stock portfolio – completely US focused
Both portfolios contain stocks, so would’ve seen losses during the stock market collapse. However, the IG Smart Portfolio would have lost significantly less than the all-stock portfolio because it was diversified. By splitting the portfolio by geography, as well as by asset classes, this portfolio would not have experienced declines across the board.
However, it is possible that the all-stock portfolio would have recovered a lot faster, as stocks tend to capture a lot of market growth. But over the longer-term, the diversified portfolio would have a steadier income and lower risk.
How to diversify your portfolio
Create an account
There are two main routes to financial markets available with us: investing and trading.
If you’re interested in traditional investment, our share dealing service would provide you with opportunities to buy and sell shares, investment trusts and ETFs. You’d get great commission rates, from £0 on US shares and as little as £3 on UK shares.1
You can also open an IG Smart Portfolio, which is fully managed by our team of experts and made to suit your risk appetite.
If you’d like to take a more speculative outlook, you can trade CFDs or spread bets. These derivative products enable you to go both long and short on financial markets, without taking ownership of the underlying assets. This creates a wider range of opportunities on both rising and falling markets.
Although diversification is commonly associated with investing, it is still a key component of risk management for successful trading strategies. It’s normal for traders to be primarily interested in one asset class, but it’s important to make sure you’re still considering your exposure in terms of risk and reward.
Diversification is best achieved by splitting your capital between long-term investing and shorter-term trades. However, you’ll always need to choose what’s right for your level of experience and aims.
Choose your asset classes
When you start making your diversification strategy, choosing the right balance of asset classes is vital. It’s important to think about your risk appetite and profit goals, as well which investments you’re actually interested in.
Our share dealing service gives you access to over 10,000 shares, funds and investment trusts, so you’ll always find something to suit you.
When you open a CFD or spread betting account with us, you’d have the choice from over 17,000 markets – including shares, indices, forex, commodities, bonds and more.
Whichever markets you decide to focus on, the most important consideration is that they are not correlated with each other. Remember, diversification should happen within and across asset classes, geographies and even financial instruments
Open your positions
Once you’ve decided which markets you’re going to trade or invest in, it’s time to open your positions.
With an IG Smart Portfolio, we’ll manage your portfolio for you, so you won’t have to do anything. If you’re managing your account yourself, the process for opening positions is simple – and largely the same whether you’re trading or investing.
All you need to do is open My IG, select the account you want to open a position from (share dealing, CFDs or spread betting) and find the market you want to trade. Then you open the deal ticket.
Remember, if you’re trading CFDs or spread betting, you’ll have the option to buy and sell each market.
Monitor your portfolio growth and health
Monitoring and evaluating your portfolio is an important part of any successful investment or trading strategy. Diversification is not a one-time effort – you have to make sure you keep your portfolio balanced.
It’s important you keep an eye on your investments to make sure you don’t have an exposure you’re unhappy with. You might have personal matters that impact your risk tolerances, such as a change in financial circumstances or different long-term goals. Or the risk profile of your assets might change, this usually happens when a stock market crash occurs.
However, rebalancing doesn’t just have to mean making your portfolio less risky. You might also want to consider adding more risk into your portfolio – for example, with shorter-term positions – when your circumstances change.
It’s also necessary to know when to get out of a position. You should keep up to date with changes in market conditions, so that you know when it’s time to close your trade entirely. Once you close one position, it’s a good idea to look at how you will readjust your portfolio.
Diversification summed up
- Diversification is the practice of opening multiple positions across a range of asset classes
- A diversification strategy can include positions across industries, asset classes or even different financial instruments – eg using CFDs, spread bets, options or futures
- The core aim of diversification is to improve risk-adjusted returns – which is the degree of risk you have to take on in order to achieve a profit
- Diversification works by limiting exposure to a single type of risk – so in the event of one part of your portfolio performing poorly, other areas should retain or even increase in value
- Not all risk is diversifiable, so it’s important to understand exactly how you can protect yourself
- Diversification requires capital as well as additional time – you’ll need to regularly monitor your portfolio’s health
- Shares, ETFs, bonds and commodities are all commonly used in diversification strategies
- When you diversify, you’ll need to choose the level of risk you’re willing to take on to achieve the returns you want
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This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.
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