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Stockopedia: strategies to diversify your portfolio and manage risk

10th February 2021 14:59

Ben Hobson from Stockopedia

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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.

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.

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.

Name

Mkt Cap (£m)

Risk rating

Relative Price Strength 1y

P/E Forecast 1y

Sector

AO World (LSE:AO.)

1,498

Speculative

+376.6

42.5

Technology

Indivior (LSE:INDV)

1,053

Highly speculative

+256.6

22.0

Healthcare

CMC Markets (LSE:CMCX)

1,193

Speculative

+189.7

7.3

Financials

Premier Foods (LSE:PFD)

791

Adventurous

+188.1

9.3

Consumer defensives

Royal Mail (LSE:RMG)

4,253

Adventurous

+170.1

17.6

Industrials

Ferrexpo (LSE:FXPO)

1,821

Speculative

+168

4.81

Basic materials

888 Holdings (LSE:888)

1,162

Adventurous

+161.5

16.5

Consumer cyclicals

Diversified Gas & Oil (LSE:DGOC)

880

Adventurous

+60.0

7.21

Energy

Drax (LSE:DRX)

1,542

Adventurous

+50.1

13.0

Utilities

Airtel Africa (LSE:AAF)

2,905

Speculative

+17.7

12.5

Telecoms

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, its 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.

interactive investor readers can get a free 14-day trial of Stockopedia here.

These investment articles are simply for generating ideas. If you are thinking of investing they should only ever be a starting point for your own in-depth research.

These articles are provided for information purposes only.  Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties.  The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.

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