How many eggs in how many baskets?
It’s one of the basic rules of investment: you should aim to build a diversified portfolio of assets to reduce the risk of a setback on any one of those assets causing real damage to your wealth. But while most of us understand the importance of not holding all our eggs in one basket, what does this mean in practice? How many holdings do you really need in a diversified portfolio?
The bad news is there’s no straightforward answer to that question, not least because some holdings give you greater diversification than others. If you own stakes in 10 funds all investing in blue-chip UK shares, you’re almost certainly less well-diversified than someone with only three different funds, but with underlying exposure to shares, bonds and property, say.
Diversification, in other words, isn’t about the number of holdings you have; rather it’s a question of how these holdings fit together. Professional investors study asset correlations – the extent to which the price of one asset tends to move in line with the price of another. To get good diversification in your portfolio, you need uncorrelated assets; the idea is that when the price of one asset is falling, you’ll get some compensation from a rise in the value of other assets you own, rather than seeing those fall too.
Above all, it is your attitude to risk and your investment goals that will determine your diversification strategy. Cautious investors may want to hold much smaller percentage of their assets in equities (and particularly overseas equities), and more in fixed-income assets and other holdings. More aggressive investors will want greater exposure to the stock market, including overseas equities as well as domestic stocks.
As you’re building a portfolio that delivers the mix of assets you’ve decided is appropriate, consider diversification at the same time. Even investors with aggressive growth instincts will usually want at least some exposure to assets other than equities; within their equity holdings, meanwhile, they’ll want a mix of domestic and international stocks, as well as exposure to companies from different sectors of the market. Equally, cautious investors with a large chunk of their assets in fixed-income holdings will want a spread of these – government bonds and corporate bonds, for example, as well as both domestic and international investments.
Moreover, diversification isn’t a one-off exercise. Over time, your investments won’t all rise (or fall) at the same pace; after a while, your carefully constructed portfolio mix will therefore have gone awry, leaving you with a range of investments that is no longer quite so appropriate to your particular circumstances. This is why all investors need to conduct periodic rebalancing exercises – say once a year – to return their portfolios to the investment mix they were aiming for when they started out, assuming it’s still appropriate.
Finally, it’s worth remembering that even well-diversified investment portfolios fall in value from time to time – during a prolonged bear market, say, or even a short term financial crisis. If you can’t risk your money ever falling in value you shouldn’t be invested in assets where this is a possibility. Good diversification will help you smooth out volatility over time, but it won’t eradicate risk altogether.