Investing Knowledge

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 (news) index tracker. And, in the true spirit of diversification, with not just one tracker provider but three.

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 declining share price. If I'd had a significant proportion of my wealth invested in Royal Bank of Scotland (LSE: RBS.L - news) (LSE: RBS), for example, I'd be feeling pretty gutted right now.

Sector simplicity

I do invest in individual companies, of course. And have done so for years. But these days, my aim is to make sure that those companies are as diversified as possible. And it's an objective that has led me to mull over what diversification actually means.

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 the High Yield Portfolio board arguing that to be invested in both HBOS and Northern Rock (LSE: GB0001452795.L - news) 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 the last eighteen months have shown, 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.

Different strokes

So true diversification involves spreading risk much more widely than simply across market sectors or sub-sectors which 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.L - news) (LSE: MKS (MKX.TO - news) ) and Unilever (LSE: ULVR.L - news) (LSE: ULVR) diversified? Not really: there's a common over-exposure to affluent consumers, moderated only by the latter's developing world exposure.

How about Marks & Spencer and Cadbury (LSE: CBRY.L - news) (LSE: CBRY), then? No: that carries an over-exposure to consumers, full stop. What about Marks & Spencer and BAE Systems (LSE: BA.L - news) (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. They're not a definitive list, I'm sure, but a very good 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?