Does diversifying your investment portfolio really work?

Novice investors are often told there are two cast-iron stockmarket rules. The first one is: time is your friend. Take the S&P 500. According to Ibbotson Associates in Chicago, someone holding a portfolio that represented the index since 1926 would have lost money just 14% of the time, based on rolling monthly five-year periods, with dividends reinvested. Over ten-year periods this drops to 4%, and over 15-year periods there would have been no losses at all.

But there's a problem with this rule, says Jane Bryant Quinn on Bloomberg. Namely, the longer you hold stocks, the greater your risk of experiencing a collapse, such as happened last year, when the FTSE 100 lost around a third of its value. If that happens just before you want to cash in and retire, you are stuffed.

Enter the second rule, which is touted as the solution: diversify.

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Diversification the theory

Diversification means that instead of putting all your eggs in one basket, you divide your money between non-correlated shares (or other assets). If two shares move together banking groups Barclays and HSBC, for example they are said to have a high degree of correlation.

On the other hand, holding a cyclical stock such as Barclays (demand for loans and credit is heavily linked to the economy) alongside a more defensive one such as United Utilities (demand for utilities tends to be fairly constant) should reduce risk as they're less likely to fall together. Even better, say fund managers, if you have a big enough portfolio, this ('non-market') risk virtually vanishes. But just how many shares do you need?

Enough can quickly become too many

It seems most fund managers reckon you need a lot of stocks to diversify properly. According to Socit Gnrale's James Montier, the average US fund manager holds between 100 and 160 stocks. But this, he says, is "madness". Hold just two stocks and non-market risk (everything except a total stockmarket collapse) falls by 42%. Hold four and it drops 68%. Snaffle up 32 and you've eliminated 96%. So a holding of 30-40 achieves "the vast majority" of diversification benefits.

The real reason fund managers tend to hold so many stocks is to ensure they achieve a return that's similar to the broad market, and don't underperform their peers. As Sir John Templeton once noted, "the poor performance of mutual fund managers is not due to a lack of stock-picking ability, but to institutional factors that encourage them to overdiversify" and rack up big trading costs in the process.

The rise and fall of 'alternative' assets

But even holding the 'right' number of stocks is no use when all shares fall together, as they did last year. So having perhaps already spent too much on an overly diversified equity fund, you face a second danger being persuaded that the way to defend yourself against a broad-based crash is to spread your cash across a host of asset classes.

Hence the growth (until recently) of 'alternative assets', including hedge funds, private equity, commercial property and even art and antiques. But there's a problem here too.

Alternative assets are not alternative

As economist Henry Kaufman once queried, what if "all securities lose value" because suddenly everything is correlated? The last 12 months is a prime example, notes Levi Folk in Canada's Financial Post.

In 2008 the Caisse de dpt et placement du Qubec (a Canadian pension fund manager that prided itself on its diversification strategy) lost $39.8bn. Each of its "other investments" strategies failed. Private equity fell 31.4%, infrastructure 44.7%, commodities 25.4%, while hedge funds and property both slid around 20%.

Worse, says Quinn, diversification can drag you further into the mire. Many investors invested in emerging markets a few years back on the basis that countries such as China, India and Brazil had decoupled from the rest of the world. That theory went up in smoke last year when the MSCI Emerging Markets index dropped 53% from January to November 2009 against just 33% for the S&P 500.

So, what's the solution?

Keep it simple. "Wide diversification is only used when investors don't understand what they are doing," says US investor Warren Buffett. Of course, not all investors feel they have the time or skill to build a portfolio of 30 to 40 shares by themselves. But if this is the case, you'd still be better off just using an exchange-traded fund (ETF) to track the market cheaply, than paying a fund manager lots of money to churn a portfolio.

And be wary of exotic 'alternative' assets. A holding of gold is good portfolio insurance against inflation (should the money printing presses get left running too long) and financial uncertainty. But beyond that, the main diversifier is bonds, which do well amid fears of deflation. For example, gilts had a great year in 2008 little else, other than cash, offered a positive return. We are less keen on gilts now due to the huge scale of government debt, but investment-grade corporate bonds look worth buying via a fund such as the M&G Corporate Bond fund (0800-328 3196), or the Invesco Perpetual Corporate Bond fund (020-7065 4000).