How to diversify your portfolio to reduce risk

Every investor should aim to have a diversified portfolio, but how do you actually achieve that and why is it a good idea?

The idea of diversification is to not put all your eggs in one basket, but to spread them around. If one of those baskets tips over, you might lose some eggs, but your overall stash of eggs is relatively unaffected. In falling markets, diversification can really come into its own, by protecting your investments from some of the worst of the stock market turmoil.

How many shares should you own?

Let’s start by considering a portfolio of individual stocks. You certainly don’t want to put all your eggs in one basket here, because if you invest in just one company and that company goes bust, you’ll have lost all your money. Less dramatically, that one holding could just be a serial poor performer. In either case, holding just one stock runs the risk of seriously damaging your overall wealth.

But conversely, there are over 500 stocks in the FTSE All-Share index, and thousands in the global stock market, so it’s simply not feasible to hold all of them individually within your account.

Source: AJ Bell

Investors can take a leaf out of professional fund managers’ books here. A typical actively-managed fund will hold between 50 and 100 stocks in it to achieve a healthy level of diversification between shares. Well-known fund managers who run highly-concentrated portfolios, like Nick Train and Terry Smith, get down to 25 to 30 stocks, which should be seen as a bare minimum for DIY investors.

That probably still sounds like a lot of companies to research and monitor, unless it’s your day job, but there’s a little trick you can use to reduce that number.

Consider investing in funds

By holding funds, either alongside stocks or on their own, you can get away with holding a smaller number of individual companies on top, because each fund you hold is already a diversified pool of stocks. That’s especially the case with index trackers, which invest across the entire market. A typical UK index tracker fund will hold over 500 stocks, while a global index tracker fund will invest in around 1,500 stocks.

If you invest in active funds or investment trusts, you also get a good deal of diversification. But while greater diversification will limit the negative effects of one company in the portfolio failing or under-performing, you still have the risk that the fund manager underperforms. Put simply, it means you can’t just own one fund and assume you’ve achieved diversification.

A portfolio of between five and 10 active funds should prevent one fund manager’s underperformance unduly affecting your wealth or seriously derailing your financial plans. Or, you could combine active funds, passive funds and stocks to achieve a robust level of diversification.

Of course, by spreading your eggs across numerous baskets, you also reduce the positive impact an investment that performs exceptionally well can have on your total wealth, compared to if you had all your portfolio in that one investment. Unless you are investing with perfect hindsight though, you’re not going to know which investments are going to perform best.

No matter how high your conviction in an individual fund manager or company, as an investor, you should always ask the question: what if I’m wrong? That’s precisely where diversification comes in, allowing you to invest with confidence, even without a crystal ball.

If you’re interested in investing in funds, you might want to check out our Favourite funds list, which has been put together by our investment research team to screen the thousands of funds out there into a shortlist.

Spread the mix further

Diversification doesn’t just apply at a stock or fund level. You should also ensure you have a portfolio that’s diversified in terms of the number of sectors within it. For instance, if you had all your money in banks before the financial crisis, you’d have lost an awful lot of money in 2008 and 2009 - it’s likely you’d still be nursing losses.

So, if you are constructing your own stock portfolio, make sure you have a blend of industries. For example, some banks, but also technology companies, retailers, pharmaceutical firms, and so on. Again, you can bolster your sector diversification by investing in funds or investment trusts, which themselves hold stocks in a number of different industries.

If you’re interested in putting together your own portfolio of funds, but need some help to get going, you might be interested to learn about our Starter portfolios, where you select the portfolio that’s right for you and get a ready-made list of funds to invest in.

But there’s another step to diversifying, which is at a geographical level. Rather than having all your money invested in one area, such as the UK, it makes sense to have a mix of investments from across the globe. The main regions to consider would be the UK, Europe, Japan, Emerging Markets and the US. By blending your portfolio in this way, if one region of the world performs poorly, your wealth won’t be too badly damaged.

What about other asset classes?

Adventurous investors and those with long investment horizons might be happy to have 100% of their portfolio in shares, or funds that invest in shares. But more cautious investors might also want to seek diversification in terms of the asset class they’re invested in too. This would mean holding bonds and cash alongside shares, and potentially gold, property and other assets too.

These assets tend to perform well and badly at different times, leading to a smoother journey for your portfolio as a whole. You can manage a portfolio of different assets yourself or you can achieve asset class diversification through a multi-asset fund, like one of our own AJ Bell funds.

With all forms of diversification, it’s important to review your portfolio every now and then to make sure it’s still balanced. If a stock, fund or region does much better than everything else, over time, you might find it makes up an unhealthily large part of your portfolio. In this scenario, you might trim it back and reinvest the profits in other areas. If it continues to do well, you’ll still have a reasonable stake, but if it underperforms, you’ll be glad you took a measured approach.

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