The Easiest Way to Protect Your Portfolio

LONDON -- "Sell in May and go away?"

Well, over the past three months, the FTSE 100 (INDEX: ^FTSE) 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 May 1 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 (NYS: AV) , for instance, is down 30% over the last three months of turbulence. BP (NYS: BP) is down 20%.Barclays (NYS: BCS) is down 29%. And Rio Tinto is down 23%.

In short, such share slumps explain 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 U.K.-based investment you can get: an FTSE All-Share index tracker.

Now, to some investors, diversification has a significant downside. There's a direct 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.

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 (NYS: GSK) , SSE, and Reckitt Benckiser become ever more alluring.

Even so, my aim is to make sure 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, "subsector" 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, and 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 homebuilder, 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 they're 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 for 2012" -- probing just these issues in respect to 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 subsectors 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 and Supergroup -- who surely sell to very different demographic sectors -- diversified? Not really: There's a common overexposure to consumers.

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

But what of Marks & Spencer and BAE Systems? Ah, now we're talking: different products, different markets, different customer groups, and 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 it's 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 favorite 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 favorite 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.

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At the time thisarticle was published Malcolm holds Aviva, BP, GlaxoSmithKline, SSE, Reckitt Benckiser and Marks & Spencer. He holds no shares in any other of the companies mentioned. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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