Portfolio diversification in action: see how it really works

We’re told not to put all our eggs in one basket. It makes sense. Drop the whole basket and you could lose all your eggs. Spread them about in different baskets and you might lose some, but not all of them. It’s about spreading your risk; something that is as important to investors as it is to poultry farmers.

An investor who “bets the farm” on one stock, sector, index or investing style for a long-term portfolio is taking a massive gamble that puts their money at unnecessary risk. It’s why diversification remains one of the fundamental rules of investing.

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Diversified portfolios won’t all look the same. Much depends on your risk appetite. But there will certainly be common themes in terms of the assets owned - equities, bonds, cash and property, plus some alternative investments.

There will also be diversification within asset classes, particularly equities where investors gain exposure across developed markets in the West and Far East, and emerging and perhaps frontier economies. This geographical spread and avoidance of “home bias” is another key rule of investing, but one which too many investors ignore.

Lessons from the past 20 years

No single asset has ever gone up in a straight line forever - fact. Whatever you own – shares, bonds, commodities, cash or even bitcoin – the return you receive will inevitably change over time, generating less or more depending on where we are in the economic cycle. It’s the same for global stock markets which have many similar but also very different drivers.

Our analysis of a selection of asset classes over the past 20 years demonstrates just how performance differs over time. The data visualisation shows that when one asset is doing well, others aren’t necessarily, and vice versa. But effective diversification ensures that at any one time there will be something within your portfolio generating positive returns. It’s not about what happens and the beginning or end of the period, but what happens in between.

Of course, a diversified portfolio won’t allocate an even amount to every asset. You’ll likely hold less in cash and have more invested in major markets such as the US. But purely to demonstrate the movement and volatility of asset values over time, our example portfolio starts with £10,000 invested in each of 14 asset classes. It tracks progress on a total returns basis - so dividends reinvested. Over the 20 years there were plenty of ups and downs, many of them as serious as they come. However, an initial outlay of £140,000 across the 14 asset classes delivered a final pot of £784,189, a handsome return of 460%.

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Japan is a great example of why it pays to stay diversified and not run scared when part of your portfolio doesn’t go well. After a 20-year boom period ended in the late 1980s, there followed more than 20 years of false dawns when bursts of optimism were just that. It wasn’t until late 2012 that a lasting recovery began that ended in a 33-year high in 2022.

It has been a period where China, India and Brazil established themselves as true growth markets and investment destinations. Each has had its up and downs, but there have been spectacular periods of outperformance, particularly in China 2005-07 and 2014-15. Brazil’s rally defied the great financial crisis longer than most, and not one of the major US markets can touch India’s post-Covid surge.

It's also good to see UK Plc represented higher up the table this time, and the FTSE 250 make the top five! Too often in recent years we’ve seen our key indices glued to the bottom of the list, but short-term performance hides the true story that UK assets have done pretty well over the long term on a total return basis. Even out-of-favour UK small-caps have had their day in the sun and are up almost 340% over 20 years.

Of course, equities have been the best-performing asset class, thanks in no small part to an unprecedented period of ultra-low interest rates, triggered by the financial crisis and reinforced by the Covid pandemic. But gold has made its case as a diversifier in a balanced portfolio, delivering strong returns through periods of crisis and inflation. And oil too has generated big returns at various points in the cycle.

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Without doubt the biggest story of the past 20 years, certainly in terms of returns, is the US technology sector. In last place and losing money in 2003 following the dot.com bust, tech shares were still underperforming cash in 2009. It wasn’t until 2010 that tech was safely out of the danger zone. After that, the rest is history, and a heady mix of low interest rates and post-crash demand recovery laid the foundations for one of the most spectacular bull markets of modern times.

From early ’09 to the end of August 2023, the Nasdaq 100 index returned over 1,700%. That’s rich reward for diversified investors with US tech exposure when the future looked bleak in ’03, and as recently as last year when this latest lengthy rate tightening cycle took the steam out of the growth stocks both in the US and elsewhere. But US tech has been the place to be in 2023. Owning the big guns - Apple Inc (NASDAQ:AAPL), Tesla Inc (NASDAQ:TSLA), Facebook firm Meta Platforms Inc Class A (NASDAQ:META), Google owner Alphabet Inc Class A (NASDAQ:GOOGL), Amazon.com Inc (NASDAQ:AMZN), and, of course, both the stock and theme of the moment NVIDIA Corp (NASDAQ:NVDA) – has been the great trade this year.

And there’s also a clear and predictable message in these numbers that keeping too much cash harms investment returns. Cash - bottom of the pile over the past 20 years - didn’t outperform equities during this golden decade for global stock markets, and data shows it will not beat shares over the long term.

Data not in the accompanying data visualisation, but interesting nonetheless, shows emerging markets in general up 428% over the 20-year period, the MSCI World index up 503% and a broad basket of commodities up 110%. If real estate is your thing, diversifying out of the UK sector would have paid off. Developed world real estate returned 385% over two decades versus 103% for the UK, although at their peak at the end of 2021, returns were 489% and 211% respectively.