Portfolio diversification

Whether you’re planning to start investing your money, or even if you’re already a seasoned investor, it’s crucial to make sure you manage the risks you are exposed to in order to avoid suffering losses to your capital. The key is to build a diverse portfolio with a mix of different investments that makes sense for your attitude to risk.

A balanced investment portfolio will contain a mix of equities (shares in companies), government and corporate bonds (loans to governments or companies), property, and cash.

Assets moving independently
Having a mix of different asset types will help you spread risk. It’s the old adage of not putting all your eggs in one basket. The theory behind this approach is that the values of different assets can move independently and often for different reasons.

Shares move in line with the fortunes and prospects of companies. Bonds are most prominently influenced by interest rates, and property values, while also influenced by interest rates, are also more closely connected to the performance of the domestic economy.

Get the right asset allocation and you could make a healthy return, while also protecting yourself against the worst downturns in individual markets.

Different investment sectors
Say you held shares in a UK bank in 2006. Your investment may have been very rewarding, so you decided to buy more shares in other banks. When the credit crunch hit the following year, sparking the banking crisis, the value of your shares in this sector (financials) would have tumbled.

So, once you’ve decided on the assets you want in your portfolio, you can diversify further by investing in different sectors, preferably those that aren’t highly correlated to each other.

For example, if the banking sector suffers a downturn, this will not necessarily have an impact on the precious metals sector. This helps to make sure your portfolio is protected from dips in certain industries.

Some investors will populate their portfolios with individual company shares directly, but others will gain access to different sectors through managed funds like unit trusts and OEICs (open-ended investment companies).

Stock market movements 
Investing in different regions and countries can reduce the impact of stock market movements. This means you’re not just affected by the economic conditions of one country and one government’s economic policies. Different markets are not always highly correlated with each other – if the Japanese stock market performs poorly, it doesn’t necessarily mean that the UK’s market will be negatively affected.

However, you need to be aware that diversifying in different geographical regions can add extra risk to your investment. Developed markets like the UK and US are not as volatile as those in emerging markets like Brazil, Russia, India and China. Investing abroad can help you diversify, but you need to be comfortable with the levels of risk involved.

Range of different companies
Don’t just invest in one company. It might hit bad times or even fail. Spread your investments across a range of different companies. The same can be said for bonds and property. One of the best ways to do this is via a unit trust or OEIC fund. They will invest in a basket of different shares, bonds, properties or currencies to spread risk around. In the case of equities, this might mean 40 to 60 shares in one country, stock market or sector.

With a bond fund, you might be invested in 200 different bonds. This will be much more cost effective than recreating it on your own and will help diversify your portfolio.

Capacity for growth
Holding too many assets might be more detrimental to your portfolio than good. If you over diversify, you might not end up losing much money, but you may be holding back your capacity for growth, as you’ll have such small proportions of your money in different investments to see much in the way of positive results.

It’s usually recommended that you hold no more than 30 investments (be it shares or bonds). If you’re investing in funds, 15 to 20 should be a maximum.

Finally, for many investors – especially those without the time, confidence or knowledge to make their own investment decisions – professional financial advice is a must.