How to diversify your portfolio

The credit crunch almost put paid to the idea of 'diversification'. Investors who'd been told not to put all their eggs in one basket watched in horror as a swathe of supposedly uncorrelated asset classes, from commodities to equities to hedge funds, all briefly collapsed together.

However, the idea of spreading your risk across different asset classes still makes sense. You just need to choose the right asset classes, and make sure that your portfolio is regularly rebalanced. Here are our tips on how to go about it.

The correlation conundrum

The first step is grasping what diversification is, and is not. One common error is to assume it means hunting for asset classes (eg, shares and bonds) that move in exactly opposite directions. A mathematician would call this perfect negative correlation so a £1 gain on your shares would be matched by a £1 fall on your bond portfolio and vice versa.

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There are two problems with this idea. For one thing, finding assets that move in opposite directions in exact lock step is impossible in the real world. For another, there would be no point. If over ten years all you do is make £1 on 50% of your portfolio every time you lose £1 on the other 50%, you'll end up not making any money, and you'll still incur trading costs.

The real aim of diversification is to reduce your portfolio risk by finding 'uncorrelated' asset classes those that tend not to move in the same direction over the same time period.

How many asset types do you need?

Even during the panic of the credit crunch, not everything fell. Perceived safe havens such as government bonds and highly rated corporate bonds, for example, enjoyed something of a mini-boom. And good old cash while also a little dull turned in positive returns even as equities plummeted.

On the other hand, some asset classes that had been billed prior to the credit crunch as 'equity diversifiers' turned out to be anything but. Hedge funds were one example while some did better than others, many turned out to be simple long-only equity funds by another name. So they were always destined to sink as fast, or faster, than many other equity-based investments.

But not all 'equities' suffered the same fate. Especially not when viewed over a decent time period. "Even though portfolios in the US market actually lost money in the first decade of the 21st century, emerging-market stocks enjoyed returns of more than 10% per year," says Princeton University economics professor Burton G Malkiel in The Wall Street Journal. So even though most equities suffered as a result of the credit crunch, diversification within that asset class would have helped your portfolio. But how many asset classes should you hold?

The case for four asset classes

Financial advisers looking for a commission may suggest you have your eggs scattered across many baskets. But don't listen, says Tim Price of PFP Wealth Management, who also writes The Price Report newsletter. Certainly, with governments printing money, "diversification across multiple asset classes may be the best way to protect and shepherd your wealth through this extraordinary period of financial and monetary manipulation". But you only need four. Tim divides his portfolio into the categories: cash and bonds; equities; absolute-return funds (genuine wealth-preservation hedge funds, not long-only copy cats); and real assets (such as silver and gold). Malkiel also favours four asset classes for his index fund portfolios. These are US stocks, foreign stocks, bonds and real-estate-linked assets.

The point is, a basket containing a few well-chosen asset classes that can defend against both deflation (cash and bonds) and inflation (real assets and equities) will serve you better than a grapeshot approach. And once you get down to the level of choosing individual shares within, say, your equities allocation, GMO's James Montier suggests you don't go too mad here either once you've bought just 32 stocks, he says, you have eliminated 96% of 'non-market' (ie, stock-specific) risk.

Don't forget to rebalance

Once you've set up a diversified portfolio, don't put your feet up. As Malkiel notes, regular rebalancing is important. You might start off with a portfolio split 25% equities, 25% bonds and cash, 25% real assets and 25% absolute-return funds. But if share prices rocket, so will your 25% equity allocation, which will change the risk profile of your portfolio. So get the balance back to 25% by selling some equities and buying something else. From 1996 to 1999, for example, a simple portfolio split 60% equities and 40% bonds, would have improved its return by 1.33% a year via rebalancing.

The flipside is that you need to watch your trading costs. So don't start tinkering until your allocations move by say 5% or more. Within your allocations, Price suggests you consider rebalancing once a single fund comprises 10% or more of that asset class. Costs can also be cut by using passive funds, such as exchange-traded funds rather than more expensive managed funds.

This article was originally published in MoneyWeek magazine issue number 514 on 26 November 2010, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.