How to successfully diversify your portfolio

A well-diversified investment portfolio is an essential part of managing investment risks. Find out how to do it successfully.

If you’re trying your hand at investing for the first time, perhaps in a SIPP or an ISA, we think index-tracking funds are a good place to start. After all, they provide exposure to lots of different company shares without having to take on the risk of holding the shares yourself.

Let’s say you invest in a FTSE All Share Index Tracker. Your money will be pooled in the fund alongside all the other investors, and invested in every share quoted on the FTSE All Share Index. This runs to more than 600 companies and covers around 98% of the UK stock market. The value of your investment will then move in line with the peaks and troughs of the index.  

As an investment that probably seems simple enough and it is. But there’s a downside: By investing in several hundred different company shares at the same time, you may feel like spreading your risk. But, don’t forget, with a tracker you’ll only get exposure to one single asset class: shares.

If UK shares suffer a dramatic fall, the value of your tracker fund will drop like a stone. You won’t be able to do anything about it except sit tight and wait for the recovery to arrive. But who’s to say how long that might take?

Of course, investment risk isn’t a reason for avoiding shares at all. But it’s a very good reason for making sure your investment portfolio is well diversified and has the right asset allocation.

Asset classes

Investing too heavily in shares will leave you vulnerable to a market collapse. But investing money in different assets classes at the same time you invest in shares, can help you to manage risk. I’ll look at that in more detail in a moment. But first, we need to look at what constitutes each of the four main asset classes:

Cash - Cash is the least risky asset class because your capital is guaranteed with interest earned on top. But your return is at risk from the effects of inflation (rising prices) and falling interest rates as any saver will know all too well. While it’s important to have some cash holdings, low risk assets don’t usually generate strong returns.

Fixed interest - Fixed interest assets include gilts and corporate bonds. A gilt is effectively a loan to the government, while a corporate bond is a loan to a company. The bondholder then receives a fixed rate of interest in return for lending capital to the bond issuer. Gilts and bonds are considered higher risk than cash because capital isn't guaranteed. But there’s an element of security provided by the fixed interest rate.  

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Shares - Finally, the shares asset class is deemed the most risky of the four because of the volatility of share prices which can rise and fall very quickly. But, on the other hand, because shares involve the most investment risk, they also offer the greatest potential rewards in terms of strong capital growth.

To give you an idea of how differently the asset classes have performed over the same periods of time, take a look at the table below:

How the different asset classes have performed

Source: Barclays Capital Equity Gilt Study 2010. Figures are annual returns after inflation to the end of 2009.* Property returns are excluded from the study. These figures are from the Investment Property Databank (IPD).

Any investor who was heavily invested in UK shares in 2009 will no doubt be pleased with such strong performance. But, as you can see, shares are more volatile than any other asset class, with returns in negative territory (-1.2%) over the last decade, despite the spectacular recovery last year.

Diversifying your portfolio

If you’re not risk averse, it may be tempting to plough money into shares in the hope your investment gamble pays off - as it did in 2009. But, equally, this strategy could have disastrous consequences since your portfolio is too heavily concentrated in one asset class.

Remember, assets in the same class usually react in broadly the same way to financial and economic changes. But, by investing in all four asset classes at the same time, you allow the poor performance of one asset type to be offset by another which is growing more strongly.

This is because of the lack of correlation between assets. Putting it another way, an asset which has a very low correlation with another should perform completely differently in response to the same events.

Recent question on this topic

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  Whats going with the stock market today? Allmost all stocks down, also the FTSE.

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For example, shares have a low correlation with fixed interest assets which means, over the longer term, when shares perform strongly, gilts and corporate bonds won’t do as well and vice versa.

In practice, a rise in inflation, for example, will likely have a positive impact on shares prices because the change suggests the economy is growing faster than expected. But this same increase in inflation will have a negative effect on the price of fixed interest bonds (because the fixed income payments going forward and the redemption value of the bond at maturity are less attractive to investors when inflation is rising). This in turn will cause yields to increase for new investors to encourage them to buy bonds.

Having said all that, in a financial crisis (think credit crunch) all four assets classes are likely be affected and fall simultaneously in which case no amount of asset allocation will help you weather the storm. But, of course, these are exceptional circumstances.

Reducing your risk

So you can see how a balanced portfolio can help to protect the value of your investments. But there’s also an additional benefit: By diversifying in this way, asset allocation experts claim you can actually take less investment risk but still achieve the same returns, or achieve a greater return for the same level of risk simply by investing in each of the main asset classes.

I’ll cover tips on how to diversify your own portfolio in a separate article. But if you’re new to investing it’s a good idea to speak to an experienced independent adviser about asset allocation first.

More: Two simple ways to invest better in shares | Top 10 index trackers