How to Build a Diversified Portfolio
Portfolio diversification is a means of tackling risk by splitting your capital over a range of different investments. In this article, we will provide a definition of portfolio diversification, explain how portfolio diversification reduces risk and share tips on how to build a diversified portfolio.
Table of Contents
What Is Portfolio Diversification?
Have you ever heard the saying “don’t put all your eggs in one basket”? – essentially, this is the principle behind portfolio diversification.
A well-diversified portfolio looks to blend a variety of investments into a single portfolio. Instead of an investor risking all their money in one company, one industry or one type of asset, it is generally accepted that it is far more prudent to create a diversified portfolio as a means of reducing overall risk.
How Portfolio Diversification Reduces Risk
The way in which portfolio diversification reduces risk is fairly intuitive, but let’s look at a simplified example to demonstrate the logic behind the idea.
Let’s say that you ‘put your eggs in one basket” and invest all your capital into one company’s stock. If that company fails and goes bust, so too will your investment and you may end up losing all your money.
Now, imagine that instead of the above course of action, you had taken your available capital and invested it equally across 20 different stocks. If one of those companies goes bust, naturally, your portfolio will feel the strain, but you will still have 19 stocks in play, which may even end up offsetting the losses from your one failed investment.
Whilst a well-diversified portfolio can help minimise risk, it will not completely eliminate it. All money invested in the financial markets is at risk of being lost. The purpose of portfolio diversification is to help reduce this risk, but it should be used as part of a wider risk management strategy.
Why Is Portfolio Diversification Important?
Portfolio diversification is important because it reduces the chance of one adverse factor negatively affecting, or wiping out, your entire portfolio.
Successful investing is all about building wealth over the long term, and you cannot succeed in the long run if you experience a loss so severe that it erases your portfolio. Diversification can help avoid this outcome.
Whilst a well-diversified portfolio may not have the potential returns associated with picking that one life-changing stock, the chances of picking such a stock are incredibly slim. Moreover, on a risk-adjusted basis – i.e. the level of returns when factoring in the amount of risk being taken - diversified portfolios are thought to outperform undiversified portfolios.
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How to Build a Diversified Portfolio
There are many ways to diversify your portfolio in order to attempt to mitigate risk across your investments. Let’s take a look at some of the different ways in which you can do this.
Diversifying Between Industries
Investors can choose to diversify their portfolios across different industries, in an attempt to offset risks associated with those industries.
For example, the shares of companies which produce oil will naturally tend to increase in value when the price of oil rises. Conversely, when the price of oil falls, the share prices of these companies tend to do so also.
Therefore, if you owned shares in an oil stock and wanted to diversify your portfolio in order to mitigate against the risk of falling oil prices, you could invest in an industry which has the opposite relationship with the price of oil.
The airline industry is an example of this. When the price of oil increases, airline stocks tend to fall, as ticket prices inevitably rise which dampens demand for air travel. Conversely, cheaper oil prices means cheaper journeys, higher demand and, in theory, higher share prices.
Diversifying Between Companies
Diversification does not have to be across different industries, it can also be sensible to diversify within the same industry across different companies.
For example, continuing with our previous example, if you are feeling bullish on the oil sector, instead of allocating all your capital to buying shares in Shell, you might want to split that capital between Shell and BP.
This way should something happen which specifically has a negative impact on Shell’s share price – a company scandal, for example – your investment in BP should remain unaffected and might even benefit at Shell’s expense.
It goes without saying that the health of an economy and the performance of assets domiciled in that economy are deeply intertwined.
Therefore, instead of investing exclusively in one country, many investors choose to diversify their portfolio across several different ones in order to offset the risk of one country’s market performing poorly.
Diversifying Between Asset Classes
Different asset classes often respond in different ways to events and, therefore, instead of focusing solely on the stock market, many investors choose to diversify across different asset classes, such as bonds.
The traditional approach for asset diversification is 60/40 – 60% of the portfolio being allocated to stocks and 40% to bonds. However, the exact ratio will depend on each investor, their goals and their risk profile. For younger investors, for example, it may make more sense to have higher exposure to stocks.
Whilst bonds will generally reduce your portfolio’s overall returns, they are considered to be a lower risk investment than stocks and, consequently, should lower the overall risk profile of your portfolio. Furthermore, the regular coupon payments can make for a welcome additional stream of income.
3 Tips for Diversifying Your Portfolio
In the following sections, we will share three tips to help you diversify your portfolio in 2022.
Look for Low or Negative Correlations
Correlation measures the relationship between two variables. A positive correlation means that two variables move in the same direction, whereas a negative correlation means they move in opposite direction.
When diversifying your portfolio, ideally you want to find investments which either have a low correlation - i.e. the relationship between price movements is minimal – or a negative correlation, so that losses in one investment will potentially be offset in another investment.
How can you find out the correlation between assets? Some will be fairly logical. Companies which operate in the same industry are likely to be strongly positively correlated, and we provided an example above – airlines and oil companies – of industries which are usually negatively correlated.
One way of checking historical correlations between assets is by using a correlation matrix. Below is an image of the Admirals Correlation Matrix which is included with the MetaTrader Supreme Edition plug-in for MT4 and MT5.
Correlation is measured between +100 and -100, with the former implying the strongest possible positive correlation and the latter the strongest possible negative correlation. A score of zero would indicate absolutely no correlation whatsoever. In the example above, the Correlation Matrix is analysing historical price data for a number of assets over the previous 200 days.
Looking at this information, we can see that, during the look-back period, Shell and BP have a very strong positive correlation (+96), whilst Shell and Disney have a very strong negative correlation (-90). Amazon and Apple have the lowest correlation (-1), implying that there was almost no relationship between their share prices during the period examined.
Consider Investing in Property
Investors looking to build a well-diversified portfolio should seriously consider investing in property. The property market tends to perform differently to other major asset classes, such as stocks and bonds, making it an ideal candidate in a well-diversified portfolio.
Real Estate Investment Trusts (REITs) are an easy and effective way of gaining exposure to the property market without having to buy physical real estate.
REITs use a pool of investor money to acquire, develop and usually manage income generating properties – such as shopping centres, apartment complexes, and office buildings. Consequently, REITs allow investors to enjoy many of the benefits associated with owning these types of properties without actually owning the property themselves.
Furthermore - in order to enjoy REIT status, which bestows tax advantages on the company – REITs are obligated to distribute a high proportion (90% in the UK and US) of their taxable income as dividends to shareholders.
However, whilst this high dividend payout ratio might be attractive from an income perspective, it leaves the REIT with a small proportion of income to reinvest into the company for future growth. Therefore, although some REITs may have attractive dividend yields, they are not always the best option for investors seeking capital growth.
Creating a diversified portfolio might seem like a difficult task – particularly for those who are not experts on the financial markets and do not have time to endlessly research different investments.
One simple, effective and cheap way of diversifying your portfolio is by using mutual funds or Exchange-Traded Funds (ETFs). A fund pools investor money to purchase a variety of assets, meaning that with just one investment, investors can instantly achieve a certain degree of diversification.
There are a wide range of different funds for investors to choose from, one option being index funds, which passively track an underlying index. For example, an S&P 500 index fund tracks the S&P 500 by buying shares in all the companies listed in the index. Therefore, from this one investment, investors will gain exposure to 500 of the largest companies listed in the United States.
Hopefully our article has demonstrated the importance of portfolio diversification and you have gained additional insight from our tips on how to build a diversified portfolio.
Whilst the prospect of creating a diversified portfolio may seem daunting, it is an important way of protecting yourself against risk. Moreover, with mutual funds and ETFs, diversifying your portfolio does not have to be as troublesome as it may seem.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.