Portfolio diversification is the secret weapon in every investor’s toolkit. It’s the strategy that makes the whole endeavour less risky, reducing the chance that you’ll lose all your money because the stock market has a bad day, month or year.
In this article, we’ll explain why it’s so important, how to do it right, and show you some popular examples of well-diversified portfolios.
Ready? Then let’s diversify.
The Speed Read:
1. By buying assets that behave in different ways during financial events, you can protect yourself against losing all of your money.
2. You can do this by buying different types of assets and investing in companies of different sizes, industries and from different countries.
3. It’s important to rebalance your portfolio regularly to make sure it remains diversified.
What is portfolio diversification?
Heard of FOMO? Welcome to FOLM — Fear of Losing Money. When it comes to investing, it’s FOLM, not FOMO, that often stops people from taking the plunge.
A recent survey by Ally Invest found that 61% of people found investing in the stock market to be “scary or intimidating,” with Millennials feeling this more than Gen X or Baby Boomers. 50% of respondents said that it was fear of making a bad investment and losing money that stopped them investing completely.
While this fear is understandable, it is also avoidable. And there’s one pro tip that can minimise the risk of losing money: diversifying your investments..
It might sound intimidating, but diversifying simply means investing in a range of assets and not putting all of your financial eggs in one basket. You do this so that if one goes down in value, you have your other investments to help you weather the storm.
Here’s what this could look like:
Simple diversification example:
In your first year of investing, you buy one share in Company X at €50. Over the course of a year, it loses 50% of its value and you sell it for €25.
You’ve suffered a €25 loss.
The next year, you decide to diversify, so buy one share in Company Y at €50 and one share in Company Z at €50.
Over the next year, Company Y halves in value and you sell that share for €25, while Company Z doubles in value so you sell that at €100.
With a €25 loss on Company Y and a €50 gain from Company Z, the combined value of your shares is €100 — exactly what you originally invested. There’s been no profit, but at least you haven’t lost any money, thanks to your diversified portfolio.
Of course, there’s always the chance that one of your investments will significantly increase in value, and you might come to regret not putting all of your money behind that one asset. But most investors agree, that’s a regret worth living with for the increased security that comes with a diversified portfolio.
Diversification takes planning and control. After all, it takes discipline to not invest everything in the latest “hot” stock. When everyone’s talking about the meteoric rise in the Tesla stock price, it can be tempting to think it will continue to rise forever. But that’s almost certainly not the case.
And it’s fair to say that some of the safe-haven assets (such as gold and high quality bonds) are seen as less exciting than the highs and lows of the stock market.
Portfolio diversification isn’t just about investing in a range of stocks, although this is also good practice. There are a number of different classes of assets that you can invest your money in, with each reacting in a different way during times of financial turmoil. And it’s this differing behaviour that makes it useful to spread your money between them.
Some of the popular asset classes include stocks, bonds, gold, and cash, and they all come with different risks and rewards (you can read more about this here).
Investing in stocks is risky, but often comes with potentially large rewards (because the stock market is known for being volatile, so in times of economic downturn, stocks are often one of the first casualties). Bonds, on the other hand, are more predictable and have lower risk (which comes with lower reward). Gold value varies depending on the price that often rises during times of financial crisis, so it’s one of the most stable investments. Finally, cash keeps you prepared for any eventuality: savings are guaranteed up to to €100,000 in the EU, so while the interest rate is poor, your money will be safe.
Diversifying your portfolio thus means diversifying your risks. Here’s what your overall financial portfolio might look like:
Primarily, anticipating that there will be downturns — and structuring your portfolio accordingly — provides peace of mind. When you’re not wholly subject to the day-to-day rises and falls of the stock market, you don’t need to spend significant amounts of time monitoring them.
Diversification also protects against the very human tendency to assume that everything will carry on as it always has. In the finance world, there’s even a name for when that doesn’t happen: black swan events.
These are rare and unexpected events that rock the economy, such as the housing crash of 2008. While nothing could have entirely protected an investor from this massive financial crash, a diversified portfolio would have helped. For instance, someone who invested solely in property would have lost huge amounts of money. Those who mixed up real estate with a range of non-property stocks, as well as bonds, gold and cash would have fared much better.
What does a well-diversified portfolio look like?
One common investing principle is the 5/25 rule: investing in five different asset classes, and holding no more than 25% of your money in each of them.
There is a limit to how far you should go. There’s no sense in investing in 100 different things, if you don’t have time to monitor them. Stick to no more than 20 individual investments (10 if you’re a beginner), so that you can stay current with how they’re performing and when it’s time to sell.
Three rules for a diversified portfolio:
1. Pick assets that don’t move in the same direction at the same time
Different assets will behave differently during financial turmoil. For instance, the price of gold tends not to go down during a recession, whereas stocks are typically badly affected. By selecting those that behave differently, your aim is to offset the losses with gains in another area.
While this might sound complicated, it needn’t be.
You don’t have to hand select your own investments to arrive at a balanced and diverse portfolio. Mutual funds allow you to add your money to a pool of investors’ money, which is then used by the investment company to buy a range of assets on your behalf, such as stocks, bonds, gold and sometimes cash.
Different types of mutual funds offer different levels of portfolio diversification:
2. Further customise your investments
While investing in funds is a quick and easy way to invest in a range of assets, you can go further, hand-selecting a range of stocks to add to your portfolio, specifically for their diversifying qualities.
Here are some guiding principles to get your started:
2.1. Vary by industry
Investing in stocks from a range of industries means that you won’t lose everything if that particular industry is adversely affected by world events. The travel industry has been a recent casualty of this, with many airlines and cruise operators seeing enormous losses due to worldwide travel bans. Many predict at least some of these companies will never recover, and Warren Buffet himself has divested all his US airline stock in the past few months.
Lacey Cobb of Personal Capital recommends that people “avoid allocating more than 4% of their portfolio to any single stock". She goes on to say that by mixing stocks from different sectors, and picking some for growth and some for value, you’ll benefit from how they behave differently throughout the economic cycle.
2.2. Vary by company size
As well as household name and blue chip companies, it’s worth investing in smaller companies to add portfolio diversification. Small-cap means a relatively small market capitalisation, the measure of a company's remaining shares. Generally, this is measured as $300 million to $2 billion, while mid-cap shares measure $2 to $10 billion.
Practically speaking, this means that there is more opportunity for growth, as these smaller companies have the potential to become something much bigger. You wouldn’t want to invest all of your money in these smaller companies, because a higher proportion of them will inevitably fail, but it’s worth taking a risk on a few.
2.3. Vary by country
Diversifying investments overseas is something that’s often overlooked, but can provide a lot of stability when the financial markets in your own country are on the downturn. This is particularly the case if you’re mainly investing in US stocks, as this is a mature market without a lot of room for further growth.
As Dan Egan, Managing Director of Behavioral Finance & Investing from Betterment, says:
International stocks and bonds are playing an increasingly large role in portfolio investing as more and more economies grow to maturity around the globe.
3. Rebalance regularly
It’s not enough to diversify your portfolio at the beginning of your investment journey. It’s something that should be checked on regularly, and adjustments made. While doing this annually is good, quarterly is even better.
You need to check the performance of each of your investments, reallocating the money from those that have grown beyond their recommended proportion of your portfolio to an investment that is underperforming.
For instance, if your risky small-cap investment has tripled in value and is now making up 12% of your portfolio, you should take the money you’ve made on that and put it towards one of your other smaller investments, or make a new investment altogether. This will reduce the proportion that that small-cap investment represents in your portfolio, back down to something under the recommended 4%.
Example of diversifications
If you’re wondering what the best proportion of investments are to achieve a well-balanced portfolio, you’ll find plenty of recommendations online. Here are just two approaches to it.
Bill Bernstein No Brainer Portfolio
Dr William Bernstein has written a book, The Intelligent Asset Allocator, using academic research and historical performance to come up with a simple portfolio that he believes will deliver good returns long-term.
Harry Browne’s Permanent Portfolio
This portfolio example is similarly simple to implement, but even safer than the No Brainer portfolio. It’s specifically designed to provide stability during any financial environment, and it’s a good example of different assets playing a different role: bonds tend to do well during economic downturns, stocks do well when there is growth, Treasury Bills (bills that governments sell to raise money for projects, which you can buy at a discount and then sell for their full value) are worth holding during a recession and gold can protect during times of inflation.
So does everyone believe in the value of diversification? Not exactly...
Warren Buffet and Berkshire Hathaway
Warren Buffet is one of the most famous investors in the world, and is generally looked upon as having the golden touch when it comes to picking good value stocks. He’s the CEO of the investment fund Berkshire Hathaway, and thanks to his investment skills, the fourth richest person in the world.
When it comes to diversification, he was once quoted as saying "diversification is protection against ignorance.” In other words, if you know your stuff, there’s no need to spread your wealth amongst a variety of investments.
Let's look at Berkshire Hathaway’s portfolio:
Currently, Warren Buffet has 78% of his portfolio in just 5 stocks, so there’s certainly less diversification than experts would recommend. But these are just the top stocks owned, and clearly shows a variety of industries, from technology to finance to telecommunications.
Warren Buffet is perhaps the most successful investor of all time, and it’s his full-time job. So unless you’re confident you can match his knowledge and skills, it would be wise to diversify more than Buffet does.
(Of course, if you really want to follow Buffet’s lead, a short cut is to simply invest in the Berkshire Hathaway fund.)
When it comes to investing, a fear of losing money is a valid concern. But portfolio diversification is what gives you the very best chance of weathering financial downturns.
Seasoned investors know that the value of investments do go down as well as up. It’s by preparing for these that you can stay calm when they happen. By spreading wealth amongst a range of assets, you can rest safe in the knowledge that there is another area of your portfolio that is not losing value, but, in fact, gaining in value instead. And isn’t this every investor’s dream?