How to Diversify Portfolio Assets Efficiently
How to diversify your portfolio assets in an efficient way is a critical when you start out investing.
In this article we’ll cover what diversification is, why it works and how you might want to go about it.
What is diversification?
Diversification, often described as the only free lunch in investing, is spreading your risk across different types of investment assets.
At its heart, it’s simply avoiding putting your eggs in one basket, but at the same time, it is an admission that you don’t know which horse to back, so you back all of them.
Why does diversification work?
Backing everyone seems a little counterintuitive when you first think about it. Sure, backing winners sounds sensible, but the idea that you back all the losers too can take a while to get your head around.
But let me explain it in terms of a simple stock market investment. Imagine you’d put £10,000 to work in the stock market for your retirement 24 years ago. You diversified your money equally between ten companies, investing £1,000 in each.
And let’s say nine of your ten investments were stinkers and went bankrupt taking your money with them. So far so bad!
But let’s also say the one that survived was Amazon. During the course of your investment period a £1,000 investment in Amazon would have grown to around £2 million.
Yes, I’ve picked a pretty good horse to back in my example. Easily done in hindsight, but look at it this way, it all comes down to simple mathematics. In reality, a company’s share price can only loose 100% of its value, whereas its potential to increase is unlimited. 200%, 500%, 1000%, 5000%, take your pick!
It means the winners will win so much that they more than make up for all the losers. I’m sure lots of companies go bankrupt everyday, but at the same time, companies like Apple, Amazon, Facebook, Microsoft, Tesla and Netflix to name but a few contribute more than enough to go around.
Going global
Now we can take that idea and expand on it. So instead of investing in just 10 companies you invest in thousands. Instead of investing in one country’s companies, you invest in companies all over the world.
And these days you can easily invest in thousands of stocks in one click though a low cost global index tracker like iShares MSCI ACWI ETF or Vanguard FTSE All-World UCITS ETF that lets you invest in over ninety percent of the investable market with one click. You get little pieces of all the businesses around that world that matter.
Whenever you buy shares in a global index tracer you are getting (almost) all the stocks. You (kind of) own a piece of the whole world.
Think about that for a moment. Wherever you look you’ll see brands that you own. You don’t have to worry about missing out on some business’ dramatic growth because you’ll own it. You don’t have to worry about some company going bankrupt because you’ll own plenty of others to make up for it.
You don’t have to worry about a country hitting hard economic times. You’ll have plenty of them to spread the load.
And the thing is, you can push this idea even further and invest in different investment assets.
Diversifying into different investment assets
You see different investment assets like stocks, bonds, gold, commodities, property or even cryptocurrency react differently to the same event. When stocks crash, other assets can go up, and even those that don’t, can better maintain their value to limit overall losses.
And limiting losses is important for a couple of key reasons.
Rule 1 – Don’t Lose Money
First and foremost it comes down to simple mathematics. £10K dropping 50% leaves you with £5K. Even if there was a quick 50% recovery, you’d still only have £7.5K.
What a lot of people miss is the fact a 50% loss in value needs a 100% increase to get back to square one. And this takes us to reason number two, psychology.
Though most people understand that we don’t like loosing money, they fail to recognise the extent of that dislike. A couple of chaps named Kahneman and Tversky came up with the notion of loss aversion, whereupon they showed losses hurt about twice as much as wins feel good.
So it is worth taking a moment to think about that 50% loss again. To compensate yourself psychologically you are probably going to need the value of your portfolio to go up something like 200% to get an equivalent level of satisfaction to make up for your losses. After all, a 100% increase just gets you back to square one.
No wonder lots of investors panic sell when stock markets go down.
Having different assets in your portfolio is a proven way to limit your losses.
If your shares drop in value but other asset prices go up by the same amount you wouldn’t even notice a loss.
For most people stocks will take center stage in their investment portfolio. Superior returns, ease of access, tax efficiency and the like all mean anybody who is serious about growing their wealth should start with the stock market.
The key question then becomes what other assets to add to your portfolio.
What is investment correlation?
The table below shows correlations for different asset classes over the last five years.
Though it can appear confusing at first glance, look a little harder and you should be able to work out what’s going on.
In short, the greener the box the better. Looking in a bit more detail 100% means two assets correlate perfectly, which in turn means when one goes down the other is sure to follow. In other words no diversification benefits are provided. Conversely, the further you move away from 100% the less correlation and more diversification is provided.
Low numbers, say less than 30 are good, single digits are great, and minus numbers are best.
Let’s say you invest in UK shares and would like to add another asset class to provide diversification. You’d want to avoid European shares (93%) for sure and neither US (74%) or Australian (75%) shares would be much better.
Instead you want to be looking at bonds. Asia (ex.Japan) bonds (-15%) and bonds from the governments of the US (-36%), Australian (-12) and UK (-11%) provide much lower correlations.
Which asset classes do I need in my portfolio?
If you study the table long enough it becomes pretty clear that government bonds are the best diversifier for UK shares (stocks).
Some won’t be happy with the conspicuous absentee asset classes, namely gold. However, it’s worth listening to what a couple of guys in the know say on this matter. Investing gurus Bill Bernstein and David Swensen provide a strong argument for investing in commodity companies like gold miners rather than actual commodities like gold itself.
In his excellent book, Deep Risk, Bernstein says commodity producers are more effective at inflation protection than commodities themselves.
And his thoughts are echoed by Swensen in Pioneering Portfolio Management, where he says: Pure commodity price exposure holds little interest to sensible investors, as long-term returns approximately equal inflation rates. Unlike commodity indices, which give investors simple price exposure, well-chosen and well-structured real assets investments provide price exposure plus an intrinsic rate of return.
In other words, investing in gold companies might be a better idea than investing in gold itself.
And this brings us to the question in hand, how to diversify portfolio assets efficiently?
Efficiency
If you invest in a global index tracker you automatically get lots of gold companies, because you own all the companies. Even if you could get a bit better diversification by investing in real gold it requires extra work, which probably isn’t worth the extra effort. And in fact, the same goes for real estate and just about everything else.
If you invest in a global index tracker you’ll have plenty of exposure to …… well…everything through the companies you own the shares in.
You are essentially, getting exposure to all kinds of different investment assets through a single fund.
The one asset class you don’t have exposure to when you buy a global index tracker is government bonds i.e. the very thing that provides the best diversification for stocks and shares.
Therefore, it makes sense to put some of your money in a government bond fund to go along with your global stocks. Here you are getting the biggest bang for your buck in terms of diversification.
By investing in two assets you are getting exposure to almost everything out there.
What kind of bond fund should I invest in?
Of course there are a lot of government bond funds out there. In practice, most people should invest in a bond fund of the government bonds where they live or at least intend to retire to in order to avoid currency risk.
Somebody living or intending to retire in the UK would usually be best served investing in UK government bonds. Similarly, somebody living or intending to retire in the US would be best served keeping their money in a US government bond fund. The same would apply across the globe in developed markets.
If you live in a developing market you might be best served investing in a global government bond fund to avoid default risk. And if you are an expat who doesn’t know where you are going to retire a global government bond fund might be the best choice for you too (we’ve covered that in more detail here).
There are lots of different government bond funds out there for you to choose from. A key difference is duration. Without getting into too much detail of the inner workings of bonds, you should know that in most cases the longer the duration the higher the interest payments you will receive from your bonds but you need to be aware interest rates.
All bonds are subject to interest rate risk. Essentially, If interest rates go up the value of bonds go down, and this affects longer duration bonds more than shorter ones.
Consequently, the best way to minimise this risk is to buy as short term a bond fund as you can find. iShares UK Gilts 0-5yr UCITS ETF would be a good example for UK investors.
If a short term bond fund isn’t available for you, then the next best thing would be a mix of all durations such as Vanguard U.K. Gilt UCITS ETF (or iShares Global AAA-AA Government Bond UCITS ETF for somebody who doesn’t know where you would like to retire).
I’ve conveniently skipped going into detail about the various types of bond risk. If you are interested you can read more about it here.
How much of my portfolio should be in bonds?
So to diversify portfolio assets efficiently most investors will be well served with a couple of funds. A global index tracker for stocks alongside a government bond index tracker.
If you are lucky you may even have access to a single multi asset fund like Vanguard Life Strategy that contains all the stocks and bonds you’ll ever need.
All you need to do is decide how much of your portfolio should be invested in stocks and how much in bonds.
This is a big topic that people have written books about and it will probably pay to do a bit of background reading before you invest. That said, as time goes by I like the 4% rule more and more and think it will work just fine for most investors.
The 4% rule says you should have 4% of your money in stocks for every year you invest with the rest in bonds. So if you were investing for 10 years you’d have 40% of your money in stocks and the rest in bonds. Investing for 20 years equates to an 80% exposure to stocks and so on.
If you are particularly risk adverse try swapping 4% with 3% so you’d have 30% in stocks for a 10 year investment.
How to diversify portfolio assets efficiently – the bottom line
Handling asset diversification in an efficient manner helps to put the odds of financial success firmly in your favour ? But how do you do it?
Well, installing a home safe for you gold, piling up barrels of oil in your garage, and keeping some highly rated vintage wine in your cellar will certainly give you some exposure to those assets and it might just provide a bit more diversification than you’d get by just investing in the companies that deal with those items, but let’s face it, it would be a lot of hassle.
Investing in a global index tracker will give you exposure to all of those. Pairing that with a government bond fund will provide the best bang for your buck in terms of diversification efficiency.
A couple of clicks on your brokerage account and you’ll be diversified across the world with maximum efficiency.
