The Easiest Way To Protect Your Portfolio

Published in Investing on 1 June 2012

Simple diversification tests can help to shelter your wealth.

Sell in May and go away? Well, over the past three months, the FTSE 100 has slid 9.4%. And having recovered somewhat by the end of April, the market has since slumped from a close of 5,812 on 1 May to 5,321 last night.

Markets have been turbulent, in short, beset by worries over economic growth, the eurozone and the state of the Chinese economy.

Even so, investors in some FTSE 100 shares have fared much, much worse. Aviva (LSE: AV), for instance, is down 30% over the last three months of turbulence. BP (LSE: BP) is down 20%. Barclays (LSE: BARC) is down 29%. And Rio Tinto (LSE: RIO) is down 23%.

In short, such share slumps explains why I'm a big fan of diversification -- which is why a fair-sized proportion of my wealth is tied up in the most diversified UK-based investment you can get: a FTSE All-Share index tracker.

Turkeys

Now, to some investors, diversification has a significant downside. There's an inverse relationship between risk and reward, they point out, and the more concentrated your portfolio, the more you'll benefit from an individual company's growing share price.

That is, of course, true. But by diversifying so broadly, I'm also protected -- as far as I can be -- from an individual company's misfortunes.

I may miss out on the ten-baggers, to be sure. But I hope to avoid the turkeys, as well.

Now, I do invest in individual companies, of course. And have done so for years. What's more, as I get closer to retirement, the charms of high-yielding giants such as GlaxoSmithKline (LSE: GSK), SSE (LSE: SSE) and Reckitt Benckiser (LSE: RB) become ever more appealing.

Even so, my aim is to make sure that the companies I invest in are themselves as diversified as possible. And it's an objective that has led me to mull over what diversification actually means.

Sector simplicity

What it doesn't mean is simply 'sector' or, worse, 'sub-sector' diversification. Yes, you wouldn't want all your eggs in the same sector -- engineering companies, for example, or retailers, or -- heaven forbid -- banks. But blindly spreading investments across sectors has its dangers, too.

Back in 2007, for instance, there were investors over on our High Yield Portfolio board arguing that to be invested in both HBOS and Northern Rock was being diversified: one was a high street and business bank; the other a mortgage bank.

Shortly thereafter, as we all know, the wheels came off that particular piece of logic with spectacular and wealth-destroying consequences.

Equally, diversification doesn't mean splitting your portfolio between, say, a bank, a house builder and a commercial property fund. As we've seen, they are both exposed far too much to the twin vicissitudes of the financial and property markets. They're in different sectors, certainly, but linked by common themes.

In short, it's important to understand the factors that underpin a sector's performance -- the demand it will experience, any regulatory issues and where the bumps in the road might lie.

Coincidentally, The Motley Fool has published a special free report -- "Top Sectors Of 2012" -- probing just these issues in respect of three sectors that appear attractive right now. Reading it certainly helped inform a share purchase that I made last week. Why not download a copy yourself? As I say, it's free.

Different strokes

In my view, true diversification involves spreading risk much more widely than simply across market sectors or sub-sectors that may, in the event, turn out to be chillingly correlated.

It involves investing in companies that sell different products in different markets, to different customer groups, and which are exposed to different economic cycles and financing pressures. And that's just for starters.

So, following this logic, and picking some large caps at random, is an investment in Marks & Spencer (LSE: MKS) and Supergroup (LSE: SGP) -- who surely sell to very different demographic sectors -- diversified? Not really: there's a common over-exposure to consumers.

How about Marks & Spencer and Reckitt Benckiser, then? Well, demand -- and therefore profits -- still depend on the consumer.

But what about Marks & Spencer and BAE Systems (LSE: BA)? Ah, now we're talking: different products, different markets, different customer groups, different economic cycles. You get the picture.

Questions to ask

So what is a good test of diversification? Here are some questions to ask, and points to ponder. It's not a definitive list, but certainly a reasonable starting point.

  • Who are the customers, and what pressures drive them?
  • Are sales defensive, or discretionary?
  • How internationally diversified are those sales?
  • Are there lots of customers, or just a few?
  • How diverse are the sources of funding?
  • What drives the business cycle?
  • Is there a common supply risk?

Incidentally, one fund manager who has consistently delivered market-beating returns by asking just such questions is Neil Woodford.

You can find out more about his approach to company and sector appraisal in this special free report from The Motley Fool -- "8 Shares Held By Britain's Super Investor" -- which lists his favourite blue chips, and explains why he thinks they're set to outperform. It's free, and can be in your inbox in seconds.

Do you have a favourite diversification test? If so, tell us about it in the box below.

Want to learn more about shares, but not sure where to start? Download our latest guide -- "What Every New Investor Needs To Know" -- it's free. The Motley Fool is helping Britain invest. Better.

Further investment opportunities:

Malcolm holds Aviva, BP, GlaxoSmithKline, SSE, Reckitt Benckiser and Marks & Spencer. He holds no shares in any other of the companies mentioned.

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

ANuvver 01 Jun 2012 , 12:14pm

No offence, but the four slumpers you mention have probably been responsible for most of the damage to your cherished tracker.

MDW1954 01 Jun 2012 , 12:45pm

No offence taken, ANuvver. FWIW, here's a fuller list:

EMG: -45.15
KAZ: -40.85
ENRC: -40.13
VED: -36.22
FRES: -30.97
EVR: -30.56
AV: -29.65
RBS: -29.23
POLY: -29.15
BARC: -28.73
RSL: -28.66
RRS: -28.47
LLOY: -28.05
WEIR: -27.59
AAL: -26.42
ANTO: -24.31
SDR: -23.42
RIO: -23.35
XTA: -23.25
GLEN: -22.31
SDRC: -20.51
BP: -20.34
STAN: -20.00

My point, however, remains: I prefer a diversified portfolio to a concentrated one. And a tracker provides a cheap way of buying that diversification.

Malcolm (author)

ANuvver 01 Jun 2012 , 1:14pm

Yuck!

I take your point about one-stop diversification, but I don't think it required a crystal ball to foresee a drop in, distilling from your list, financials and commodities.

So why not avoid these sectors, rather than pile into a tracker that includes them? I know, cost-averaging etc etc, but if you see a truck heading for you, you tend to get out of the way.

I don't think there's anything wrong with a touch of sectoral market timing, even for the most conservative investor.

Which I am, and diversified too. I may be bleeding from the ears on my AV position now, but the bottom line is still a healthy green and later this year I may well be buying banks.

Best, J

QuantumDealer 01 Jun 2012 , 1:34pm

If investors truly believe in long-term investing then some of the larger-cap energy & mining stocks are beginning to look interesting again. We are undergoing a 'panic sale of quality assets' as well as a 'throwing out of the trash'.

I like companies with quality assets such as BG Group or BHP Billiton. Global leading companies with balance sheets that can support continued investment in quality assets from distressed sellers in the next 12 months. I always find 'wide moats' very difficult to explain. Does BHP have a wider moat than say a RIO? Does Unilever have a wider moat than Danone or Nestle? Does Shell have a wider moat than BP, Chevron, Exxon? It is so hard to work that out for a private investor, I think. But, I am happy to invest in those businesses that I believe have the capacity to enhance their portfolios of quality assets, such as BG Group's Brazilian gas & oil fields, at lower prices than they would have imagined they could have added to them at. I also try and imagine how those businesses may look in 5 years time. Will we really be in as bad a place as we 'appear' to be in right now, then? Will the weaker/marginal players be crowded-out as demand for every sector shrinks and only the strongest survive? Well, I believe that the strong do survive within sectors. Large companies will continue to be able to continue to finance their investments in quality assets at relatively low rates of interest which will mean that when some of this fear subsides, a fair-value of these newly-acquired assets will be more evident in the underlying share prices.

I am keeping the faith in equity-based investing and in investing in those businesses with strong assets who have the capacity to make high-quality, strategic additions to their existing quality asset portfolios during these difficult economic times.

JohnnyCyclops 01 Jun 2012 , 6:43pm

So, following this logic, and picking some large caps at random, is an investment in Marks & Spencer (LSE: MKS) and Supergroup (LSE: SGP)

Supergroup a large cap? Really? I thought they were down around £250m and heading for the FTSE250 exit p'raps. There are far far more fundamental reasons not to touch SGP than that they're in the clothing retail sector with a real large cap like MKS.

goodlifer 01 Jun 2012 , 10:57pm

"Sell in May and go away."

If there's really anything in this, it follows as the night the day that scavengers like me (and you?) should stick around to pick up some of the juicy titbits that are likely to be available over the next few weeks at bargain-basement prices.

MDW1954 01 Jun 2012 , 11:14pm

Hello goodlifer,

I replied to your -- sadly critical -- comments on that other article. Did you see the reply?

Reference this comment, I bought today. The Fool's disclosure rules won't permit me to say what, but regular readers won't be surprised.

Malcolm (author)

goodlifer 01 Jun 2012 , 11:17pm

"A fair-sized proportion of my wealth is tied up in the most diversified UK-based investment you can get: a FTSE All-Share index tracker."

A tracker's very likely the best solution for people who don't have the time or the inclination to give their investment the attention it needs.

But isn't it blindingly obvious that any serious investor - let alone a professional - who can't do better than a tracker has got to be pretty bad?

goodlifer 01 Jun 2012 , 11:40pm

"Did you see the reply?"
Yes, and I was once again pretty baffled, but there you go.

What's sad about being critical?
Surely the point of these columns is to sift the grain from the chaff?
Personally I'd welcome much more criticism of the things I come up with.

When it comes to investment , there's no time for sentiment - truth comes before ego every time.

simonfly747 02 Jun 2012 , 3:28am

Re; 'how to shelter your wealth';

I think it important to analyse one's own reason for investment'
Is it to seek capital growth, or to derive an income form one's accumulated wealth?

If it is the former, then those investors are likely to be in for a rather 'tense' time, as the markets Worldwide gyrate up and down as mostly bad news, interspersed by occasional titbits of good news drive them.
The incredibly complex computer programs in place to extract value from the smallest of individual share movements, employed by the huge financial organisations are likely to continue to make these 'gyrations' ever more difficult to predict.
Incidentally the 'interconnect' between World markets, seems to grow ever stronger, making it extremely difficult to search out any particular 'safe haven' market.
(I make this comment, after reading the 'diary of a private investor' this morning in the Telegraph, who had sought some degree of protection form the Euro crisis, by investing in the Far East. Unfortunately his strategy had not served him particularly well)

If it is the latter, then it is necessary to take a somewhat longer term view.
The value of your shares is only really significant on the day you buy and the day you sell.
Having selected and invested in one's portfolio of chosen companies for (dividend) income, then the instinct should be to stay with them, unless their is an overriding reason to reconsider any particular company in the portfolio.
The costs involved in selling and buying shares, plus the effect of capital gains tax, must weigh on any decision to change the portfolio.

I also feel it appropriate to comment on the much stated 'advice from the experts' often published in some of the UK daily newspapers, that indicates a requirement to move to cash, bonds or annuity, approaching retirement.
As we are all apparently going to live 'forever', such a move is likely to result in penury in later retirement.
(A percentage of one's wealth in cash is a must to assist in smoothing the troughs).

Of course I track the value of shares in my portfolio most days and on those days when the values have risen, one tends to feel pleased and on those days when values have fallen, one feels disappointment.
Either way, a glass or two of red wine helps.
What always pleases is the dividend account statement each month.

With a long term view in mind, it must be the case that current market valuations of many of the FTSE blue chips, represent a good buying opportunity for those embarking on an 'income' strategy.

amsterdamgroove 02 Jun 2012 , 6:08pm

@simonfly747 I really enjoyed reading your comment. Very informative.

goodlifer 02 Jun 2012 , 9:32pm

So did I, simonfly747

Thinking about making a comment or two.

goodlifer 02 Jun 2012 , 10:36pm

"The value of your shares is only really significant on the day you buy and the day you sell."

Isn't this just as true for those seeking capital growth?

If I think I'm any richer just because the paper value of my portfolio's gone up I'm either away with the fairies or just kidding myself

"One tends to feel pleased (when one's portfolio's gone up) and on those days when values have fallen, one feels disappointment.

I still react that way with my heart, though my head tells me it's stupid to do so.

What does the Oracle say?
"If you expect to be a net saver during the next 5 years, should you hope for a higher or lower stock market during that period?
"Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall
."This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices."

Kind of counter-intuitive - if isn't hurting,it isn't working. just grit your teeth...

simonfly747 03 Jun 2012 , 4:07am

Goodlifer

Many tks for your thoughtful comments.

"Isn't this true for those seeking capital growth"?

Absolutely and in fact more so,
I think the point I was trying to make was that (my own) elation on any day when the portfolio has risen is just irrational.

"Prospective purchasers should much prefer sinking prices"

Again, I entirely agree. However as you say "counter-intuitive"

goodlifer 03 Jun 2012 , 7:38am

Hi again simonfly747

I'm primarily - I think! - interested in income, but does that mean I'm not really interested in growth.
Why shouldn't I be interested in both?

simonfly747 03 Jun 2012 , 8:52am

Goodlifer

Perhaps my goal is best described as 'to grow the income'!






goodlifer 03 Jun 2012 , 1:19pm

I'll drink to that.

moreuseless 04 Jun 2012 , 1:07pm

I don't post often but felt I should add to both simonfly747 and goodlifer (who's advice I tend to follow/agree wtih).

I am an income investor and my only criteria is yield and whether the company will stay in business long enough to make some money out of it!

I agree in diversification and use a broad description such as insurance, retail etc. I also have a set limit on any one company to limit potenital losses.

I do not agree with the rules about diversification by asset classes as I see equities generally being better. I do have a large amount of cash but that is earmarked for specific items and so is ringfenced.

The principle behind my investments is that I am buying from myself an annuity i.e. having my cake and eating it. Why should I give all my hard earned money to someone else just to get some pocket money each year?

It is fun to watch the share price go up and down but at the moment I would prefer down as I still have money to invest. When I run out of money to invest then I will want them to soar!

Conversely I have money in growth funds which I wish would improve so I could swap/sell them for income shares. Ah well such is life.

Summerwood 04 Jun 2012 , 2:53pm

It is not diversification that is the most important thing but correlation between holdings and assets. You may be well have a well diversified equity portfolio but the individual holdings may all move together.

My investments are all in my sipp so it is a case of protect and grow. I have 5% in an All-Share tracker but 25% in small and medium value companies with decent niches such as Carrs Milling, Hilton Foods, Nichols, Portmeirion, William Sinclair, N Brown, Pennon. KCOM, John Menzies, Chemring, Treatt and Computacentre. Shares I can figure out and make sense off. How on earth can any private investor decide on Aviva or any financial for that matter ?



MDW1954 04 Jun 2012 , 9:11pm

Hello Summerwood,

I know several of those companies, and see where you're coming from. Interesting.

Cheers,

Malcolm (author)

goodlifer 05 Jun 2012 , 1:15pm

moreuseless
04 Jun 2012 , 1:07pm
"It is fun to watch the share price go up and down but at the moment I would prefer down as I still have money to invest. When I run out of money to invest then I will want them to soar!"

Got it in one!

RegDiversify 06 Jun 2012 , 1:25pm

I favor defensive non-cyclical stocks that pay a good dividend.
I avoid Banks and Miners which drive the Footsie 100 and tracker funds.
My income is better than I can get from Trackers, Annuities and Funds.
If I like a stock in a particular sector I will buy a second in that sector so I don't get stung by a profits warning or mishap.
I liked RSA so I also bought AV..
I also liked TSCO but I also bought SNBRY.
I liked AZN but also bought GSK.
I liked BP. but also bought RDSB.
I call this my Noah's Ark principle, two by two.
If the dividends remain good hang in there and buy more when the price has fallen.


TomRoundhouse 06 Jun 2012 , 2:31pm

Rather than a tracker, I prefer the Vanguard UK Equity Income Index fund. It excludes high yielders with poor prospects but includes high yielders with good forecasts of rising divs. Since launch in June 2010 it has outperformed the FTSE by almost 20% which is not too shabby and best of all it is as cheap as chips.

goodlifer 07 Jun 2012 , 10:20pm

Hi moreuseless.
"I should add to both simonfly747 and goodlifer (who's advice I tend to follow/agree wtih)"

Health Warning !!!!!!!
Naturally I'm pretty chuffed to find someone actually reads some of my contributions. but. but, but
I've got my share of vices, but I'm the last person to think I'm qualified to give anyone advice about investment - I'm very much a Johnny-Come-Lately to the Great Game.

Why then do I see fit to shoot my mouth off so freely in these columns?
Partly because I find it helps articulate my thinking to comment on other Fools' contributions,
Partly because my comments often provoke them to make insightful replies.
And I rather enjoy tailing my coat from time to time - you've probably noticed I've done so higher up, and I'm still hoping Malcolm will rise to the bait.

Two more points;
One, an important reason I'm such an avid reader of our Foolish experts is that balance sheets and accounts are one of my numerous blind spots, and I tend to rely on them to warn us of hidden dangers.
Two, I do my very best to stick to the bleeding obvious..

moreuseless 09 Jun 2012 , 1:19pm


Goodlifer
07 Jun 2012 , 10:20pm
"Health Warning !!!!!!!
Naturally I'm pretty chuffed to find someone actually reads some of my contributions. but. but, but
I've got my share of vices, but I'm the last person to think I'm qualified to give anyone advice about investment - I'm very much a Johnny-Come-Lately to the Great Game."

I agree with you (here we go again!)
I think your last point "I stick to the bleeding obvious" is why I tend to agree with you.
There are lots of people who do serious research but as I am lazy I stick to what I know and what my gut tells me and take time to make a decision.
There are a couple of other guys who's comments I like (but can't remember their monikers one is FS97 or something like that) and I always read both the article and the comments before I make any decision!

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