Stockopedia: strategies to diversify your portfolio and manage risk

How to limit threats and make your money work harder.

Warren Buffett, one of the world’s richest investors, describes risk in simple terms. He says it’s summed up as the chance of permanently losing all your capital. Or, to a lesser extent, just not making a good enough return on an investment that you’ve made.

Whether you’re a billionaire or new to the stock market (or somewhere in between), Buffett’s words ring true. The nuts and bolts of risk are really about the chances of losing money. And never is that peril higher than when markets become very bullish and investors get carried away.

We saw an interesting example of this recently involving the US company GameStop (NYSE:GME), which saw its share price soar and then collapse.

What looked like a battle of wills between rebellious traders on social media platform Reddit and hedge funds traders on Wall Street probably sucked in many naive investors. A lot of them will now be wondering how and why they lost so much money.

These kinds of events - and the fear of the damage that bad risks can do - is why strategists and academics have spent years figuring out how to measure risk as a number. When you hear about risk today, it’s often framed in terms such as volatility and correlation.

These concepts don’t define what risk is, but they can be useful. They can help you think about how an individual share tends to move around its average price over time, and how different shares tend to move in relation to one another.

• Funds and investment trusts: how small is too small?
• When it is worth paying a premium for an investment trust
• Are you saving enough for retirement? Our calculator can help you find out

This kind of information can offer a view of how a share might impact a portfolio. Mixing and matching different types of shares can then help to achieve some balance across the holdings.

Add to that other factors such as personal risk appetite, the expected investing lifetime, income, goals and different investment allocation...and it’s possible to start building a picture of what a dependable stock-market portfolio might include.

How to limit risk and make money work harder

Diversifying a portfolio is one way of making your money work harder while cushioning the impact of risk.

It can be approached in different ways. It might mean mixing small, mid and large-cap stocks. After all, fast-growing small-cap companies can produce stunning profits in buoyant conditions.

But smaller firms also carry more idiosyncratic risk, which can make them vulnerable. Larger companies can be better at fending off the impact of market shocks, but their growth rates tend not to be that high.

You can also spread risk by investing across so-called super sectors: cyclicals, defensives and sensitives. Generally, cyclical sectors are more sensitive to macroeconomic trends and the health of the economy and consumer confidence.

By contrast, defensives sell goods that we buy in good times and bad. They include drug companies and utility groups. In between are the sensitives, which move with the economy but not as much as cyclicals do. 

Another way of thinking about diversification is to consider buying into foreign markets. The London Stock Exchange only accounts for around 8% of global stocks. And while the FTSE 350 does have some natural foreign exposure, a truly diversified world portfolio would theoretically include more than 90% in foreign holdings.

• Six speculative UK share ideas for 2021
• Read more of our content on UK shares here

A fourth diversification option is to hold stocks with different levels of historic volatility. Periods of high and low price volatility tend to be cyclical. In calm conditions it’s the higher volatility stocks that catch the eye of investors. Yet research shows that it’s the cheaper, less volatile stocks that actually often outperform everything else over time.

Screening the market

To put some of these ideas into practice, here’s a screen that picks out the top-performing stocks from each super sector over the past year (based on relative price strength against the market). 

The risk rating shows a measure of volatility calculated using three-year standard deviation - with the spectrum ranging from conservative to balanced, adventurous, speculative and highly speculative. As you can see from this list, the three most volatile classifications are the only ones represented here - which reflects the performance of more speculative stocks over the past year.

For investors watching the headlines, the episode with GameStop last week will have been met with bewilderment in part. It offered a snapshot of behaviour that really only comes to the surface when confidence and willingness to invest with little concern about risk, is sky high.

But at a time when the economic conditions remain so uncertain, it’s worth remembering some of the rules that can protect a portfolio over time. Risk management, with the help of diversification, can offer some protection - and help you sleep at night - when others in the market seem to be losing their heads.