In my last post I asked “How many different shares should you hold in your portfolio?“. But there is more to creating a diversified portfolio than simply owning shares from many different companies.
You wouldn’t have diversified very much if you won the lottery and then spent it all buying every pub in your local high street. That example highlights two important diversification factors which go beyond how many companies you own: Industry and geography.
Diversification by industry
Industrial diversification is a powerful way to reduce risk in a portfolio. That’s because different industries have different business cycles and fall in and out of favour with investors at different times.
A good example of this occurred in the credit crunch when cyclical businesses like car manufacturers were falling through the floor. Many investors moved into non-cyclical business that sold things like soap and toothpaste, items that were relatively unaffected by the downturn.
The result was that some shares went up whilst others went down. These movements in share price can cancel each other out to a degree, and so a portfolio of companies in different industries can be less volatile than any one of those companies individually.
An extreme and unlikely example is the case of a portfolio of two companies, A and B. The share price of both companies is 100p and company A’s shares always gain 10p when company B’s shares lose 10p, and vice versa. Even though the shares of either company can gain or lose 10p the portfolio overall never gains or loses anything. That will be true as long as the shares move in exactly the opposite direction to each other.
In the real world a correlation of -1 (i.e. shares which move exactly opposite to each other) doesn’t happen, but the shares of companies in different industries do often move in different directions to different degrees, and the reduction of volatility at the portfolio level is real.
By deliberately selecting companies from many different industries it really is possible to reduce risk without reducing returns.
So what might a sensible industrial diversification strategy look like? My approach is to rely on FTSE Sectors as a rough guide to what sort of business a particular company is involved in. You can find these FTSE Sectors quoted on most financial web sites.
In order to get a balance between enough diversification to reduce risk and enough concentration to take advantage of sectors that are out of favour, I limit my portfolio to no more than 10% in any one FTSE Sector.
With a portfolio of 30 holdings that means no more than 3 companies for each sector (as each company is typically around 3-4% of the total). This allows me to focus in on a sector such as Food & Drug Retailers or Non-Life Insurance, without getting over exposed to any one area.
Diversification by geography
The next step in a basic diversification strategy is to think about where in the world the companies in your portfolio get their money from. If every single company gets 100% of its revenues from within the UK then that’s a substantial concentration of risk.
What if the UK becomes the “sick man of Europe” again? What if the pound goes through years of hyper-inflation as the government battles its debts? What if something even worse happens?
Fortunately in the UK we have access to one of the world’s major stock exchanges. The FTSE indices, especially at the larger-cap end, contain many companies that generate most of their revenues and profits from overseas.
For example, in aggregate the companies in the FTSE 100 generate around three quarters of their profits from outside the UK, so there really is no need to be over exposed to the UK just because you might live here; if anything, living and working in the UK is perhaps even more reason to invest internationally.
So if the FTSE 100 gets 75% of profits from international sources, what’s a reasonable level of geographic diversity for most people?
Again it comes down to a trade-off. This time it’s a trade-off between being flexible enough to invest where the best opportunities are, versus the desire to reduce country specific risk. In my case I want at least 50% of a portfolio’s total revenue or profit to come from international sources.
So far I’ve found that this approach has worked quite well; it isn’t overly restrictive, but is has occasionally forced me to “go international” rather than invest in another UK-dependent company.
I must admit that diversification isn’t the most exciting subject, but its importance cannot be overstated.
By spreading your money across many companies, and ensuring that they come from a diverse range of industries generating profits from all across the globe, I think it’s relatively easy to build a portfolio that should be able to withstand just about anything short of nuclear war.