Golden Rule - Diversification

It took until the 1950s for Harry Markowitz, nobel prize winning mathematician, to turn common sense, 'don't put all your eggs in one basket,' into what is now known as the portfolio theory; the idea that you should diversify your investments across different sectors and different instruments. This, in effect minimises your risk.

The basic idea is that the returns you are likely to get from investing in just one share do not justify the extra risk you take on by exposing yourself in this way. So, you try to estimate the returns you would like - your expected returns - and minimise the risk associated with your expectations.

You can avoid some of the risk involved by buying stock in companies whose share prices that do not correlate. The classic example is buying shares in an ice-cream parlour and umbrella manufacturer. If you only hold the umbrella maker and it is a dry year you will not do well. However, your friend who holds ice cream shares is on to a winner. Therefore, the sensible thing would be to buy a share in each then you would not have to worry about the weather any more.

By holding both the umbrella maker and the ice cream maker and hence you do not get the potential payoff that comes with taking the ‘weather risk.’. Therefore, although you could take a punt on the ice cream maker in one year, this is little more than gambling on the weather. When you hold both, there is no risk that you will be caught out by the weather, yet you will always see a return. The returns from this approach will be more stable over time than that which you would expect from just holding one of the shares. Since you have removed the effect of the weather, the return is dependent on company performance.

Shares that behave like the umbrella and ice cream shares are said to be 'negatively correlated', that is they move in opposite directions given the same piece of news. Shares that move in the same direction on the same piece of news are 'positively correlated'. An example of the latter would be an ice-cream manufacturer and a swimwear producer. The degree with which shares vary together is called 'covariance'. To reduce risk exposure, you should pick shares with low or negative covariance.

Therefore it is possible to reduce the risks in a portfolio by owning a range of shares from diverse sectors. It would be wise to note that, diversification at random i.e. by throwing darts at the FT, is not as efficient as calculated diversification.

An understanding of portfolio theory will guide your portfolio strategy. Thinking about the risks attached to each share, and how closely linked they may be to each other, as well as your expected returns will allow you to have a balanced portfolio. You will then be clearer about the type of shares that you want to buy, and the conditions under which you will buy them.