A key lesson from this year’s ups and downs on the financial markets is the importance of diversification. But what exactly does it mean to be truly diversified? As we explain in the latest article in our series on the different types of investment risk, it’s more complicated than not putting all your eggs in one basket. There are, in fact, several ways in which your portfolio can become exposed to concentration risk.
Every investor will have heard of the need to diversify. It is one of the most common pieces of investment advice that you should make sure that your portfolio has a number of different parts to it.
The biggest reason for this is that you want to spread your risk. You don’t want the performance of one stock or one sector or one country determining what happens to all of your money.
This is known as concentration risk — the risk that your whole portfolio can be hurt by just one thing going wrong.
An example would be investing in property. If you had £1 million, you might be able to buy a nice two-bedroom apartment in Shoreditch to rent out.
That sounds fairly attractive, but if something went wrong in the area and the bottom fell out of the Shoreditch property market, you might be left holding a property that is suddenly worth a lot less. You would also find it more difficult to rent it out.
If, however, you took that same £1 million and bought a global listed property index tracker, you would get exposure to dozens of different property companies, operating in a wide range of sectors from warehousing to hospitals across the world. Even if something went wrong with one of those companies, or in one of those areas, the rest of the portfolio would still be okay.
You are therefore minimising your risk and lowering your chance of suffering major losses.
The benefits of indexing
This is one of the strong arguments in favour of investing in passive funds. When you buy a fund tracking the MSCI World Index, for example, you are getting exposure to over 1,500 different companies, listed in 23 different countries. None of the stocks makes up more than 5% of the index.
This portfolio is therefore naturally diversified.
However, it’s also important to bear in mind that this isn’t always the case with passive funds.
In the heady days of the 2000 market boom, for example, Nokia had grown so big that it accounted for 70% of the market capitalisation of the Helsinki Stock Exchange. Anyone buying that index was therefore getting a highly concentrated portfolio — with the performance of one stock essentially determining its fortunes.
And, in this case, they would have suffered terrible losses as a result. Nokia’s share price peaked at over €62 that year. By 2012, it had hit a low of under €2. Over the same period, the Finland Stock Market Index fell 70%, and it is still nearly 40% below its 2000 peak.
Types of concentration risk
It’s also important to bear in mind that you can be exposed to concentration risk in different ways. Just holding a number of different shares doesn’t necessarily mean that you are truly diversified.
For example, if your portfolio is 20 different technology stocks you might think that you are satisfying the need not to have all your eggs in one basket. However, if the entire technology sector takes a hit, the fact that you have 20 different shares isn’t going to be much help. They will all go down together.
You must therefore think about being diversified across different sectors.
But even that is not necessarily enough. It’s also important to avoid concentration risk to specific economic factors.
A portfolio of banks, property stocks, insurers and consumer discretionary stocks might sound well diversified, for example. But all of those sectors will be impacted by changes in interest rates, and therefore move in similar ways.
A final thing to think about is how much of your wealth is concentrated in the country in which you live. If your home, your job and your pension are all in the UK, you are probably lacking some diversification.
Since we all tend to prefer what we are familiar with, this is something investors all over the world face. It is known as home bias — where the bulk, or even the entirety, of their wealth is held in and exposed to the country in which they live.
For UK investors, the problems with this have been evident over the last few years. The poor performance of the London Stock Exchange and the weakening pound have meant UK investors have done significantly worse than those elsewhere, particularly in the US.
It is therefore always a good idea to have a global view so that your portfolio isn’t impacted by what happens in just one country.
Investing globally also means that you can get exposure to companies and sectors that you might not find in the local stock market. And that will help diversify your portfolio even more.
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