How do i calculate the diversification of my investment portfolio?

Abatement

I was trying to work out what my current investment portfolio looks like, in order to assess how well 'diversified' it is. I thought this would be simple, but now I've tried to do it, I'm not actually sure how to do the calculation.

My wife and I have the following assets/liabilities (for simplicity I've just counted everything as jointly owned):

A property worth approximately £650k (which we live in)
A mortgage of approximately £200k
Cash savings of approximately £70k
Various index trackers worth approximately £40k (mostly in equities)
Pensions worth approximately £140k, again mostly in equity index trackers.

So how do i put those things together? In particular, does my level of cash include my mortgage (i.e. do i have a negative cash holding, in effect, of -£125k?) on the basis that both the savings and the mortgage are exposed to (say) inflation?

And should I include my pension holdings in with the index trackers? Or exclude them on the basis that i won't be able to access them for 30-odd years?

And do I count my house as a £650k exposure to 'property', or ignore is as I'm actually living there?

I'm sure this shouldn't be so difficult...

eskbanker

Not sure there are any rules as such, a lot depends on what you're trying to achieve and why (is this some sort of academic exercise or aiming to support specific investment decisions?), but personally I'd correlate the mortgage with the property value rather than cash, i.e. regard the property investment as being a net £450K.

masonic

The main purpose of diversification is to take a basket different investments, which are each subject to price volatility and uncertainty of future returns, and combine them such that the result is a portfolio that is subject to lower volatility and more predictable returns. In the extreme case, invest in a single fledgeling company and you stand a fair chance of losing all of your money, but might get lucky and see it go up in value an order of magnitude. Hold a larger number of such companies, spread across different industries, and you would likely get a more modest return, but with much less risk of significant loss.

So potentially any asset you hold that fluctuates in price in an unpredictable manner should be included, but the key factor is that something that undergoes very similar price fluctuations as something else is not going to contribute much to your diversification. So, the correlation of pairs of assets is often used as a measure of diversification. You can find that out on Trustnet if you plot funds against one another and use the 'Comparison report'.

Arguments could be made for not including your cash or debts, depending on what you are really wanting to understand about your investments. They will give your investments some leverage/dilution, but are not strictly diversifying in the sense I would use the term. Similarly, your property could be included, but the argument against it would be that you will always need somewhere to live. However, if you plan to downsize or sell up and retire abroad in the future, it could be relevant.

One thing for sure, there isn't a generally accepted way of coming up with a number, or even a set of rules, so have fun!

masonic

eskbanker wrote: »

but personally I'd correlate the mortgage with the property value rather than cash, i.e. regard the property investment as being a net £450K.

Interesting. I wouldn't do that because if you purchase a £650k property with a mortgage, then you are subject to the price movements of £650k of property regardless of the size of the mortgage.

Pincher

Something about negative correlation and reduced composite volatility, I guess.


Buy stock from the Uzbekistan stock exchange, guaranteed to have no correlation with your portfolio.:D

Abatement

Thanks all. To be clear, when I say 'calculate the diversification' I just meant, work out that my portfolio is split into x% cash, y% equities, z% property etc. Nothing more technical than that!

I suppose the next question is whether the split looks broadly sensible? I sense that I should have less cash and more equities (passive index trackers naturally - I've been reading monevator...)

masonic

Abatement wrote: »

I suppose the next question is whether the split looks broadly sensible? I sense that I should have less cash and more equities (passive index trackers naturally - I've been reading monevator...)

That's very difficult to say without knowing your risk tolerance, your reason for holding the cash (for example, you could be holding it as a proxy for Government bonds given the current economic conditions), and a breakdown of your equity investments. Your direct property is always going to be a bit out of whack because property is quite lumpy. It will therefore come down to whether cash:S&S is appropriate for you and the actual funds you hold and their respective proportions will have some bearing on that as well.

Abatement

masonic wrote: »

That's very difficult to say without knowing your risk tolerance, your reason for holding the cash (for example, you could be holding it as a proxy for Government bonds given the current economic conditions), and a breakdown of your equity investments. Your direct property is always going to be a bit out of whack because property is quite lumpy. It will therefore come down to whether cash:S&S is appropriate for you and the actual funds you hold and their respective proportions will have some bearing on that as well.

Thanks for the response.

The risk tolerance thing is quite difficult to answer, but I suppose that the following are relevant:
- I can't see us needing much of the cash in the near future - both my wife and I work in reasonably secure jobs, and we probably have enough equity in our house to cover any reasonably foreseeable house moves.
- Related to the above, we'd probably be able to stay in any equity investments for the reasonably long term. In all honesty I can't think of any specific reason why we'd need the money before retirement, but obviously 30 years is a long time, so I can't rule it out.
- I'm not inherently risk averse. I understand that equities means potentially significant losses, and am prepared to trust the market. That's not to say I wouldn't be upset if we lost, say, 50% of our investment, but who wouldn't be?

The investments outside the pension are just in bog standard index trackers (a variety of Vanguard ones). My rough calculations tell me that we've got about 30% in the US, 30% in the EU, 13% in the UK, and smaller amounts in Asia, Emerging Markets and miscellaneous others. There's also about 5% in a mixture of bonds.

I'm not sure about the split of the pensions - I'd have to look it up, but it's all in equity focused 'lifestyle' type funds, so invested in a range of geographies, with probably a small amount of bonds.

Is that useful additional information?

masonic

Abatement wrote: »

Is that useful additional information?

Yes, I think that answers all of my questions. The main aspect of risk tolerance is how much could you lose and still be able to sleep at night and not be too tempted to give up and sell everything. If that's around 50% for you, then based on historical worst case scenarios, you'd be aiming for about 60% equities overall (ignoring your home for now). If you could stomach worst case falls of 60%-70%, then you might be ok with 80% equities or more. You'd always want to keep a few months living expenses as an emergency fund though, even if you decide your risk tolerance is very high.

So, depending on how you want to treat your pension (you might be a bit more relaxed about it since you can't get at it for quite some time), that might suggest you are a bit heavy on cash and could invest some of it in your S&S ISA. In terms of your geographic split, it looks fine, so it would probably be a case splitting the money between the same funds in that proportion.

Traditionally, Gilts would be used to balance out the equities, but with the current low yields and potential for capital loss if interest rates rise, sticking to cash could be the most sensible option right now. You could look to add a corporate bond fund if you wanted some further diversification in your defensive assets.

Abatement

masonic wrote: »

Yes, I think that answers all of my questions. The main aspect of risk tolerance is how much could you lose and still be able to sleep at night and not be too tempted to give up and sell everything. If that's around 50% for you, then based on historical worst case scenarios, you'd be aiming for about 60% equities overall (ignoring your home for now). If you could stomach worst case falls of 60%-70%, then you might be ok with 80% equities or more. You'd always want to keep a few months living expenses as an emergency fund though, even if you decide your risk tolerance is very high.

So, depending on how you want to treat your pension (you might be a bit more relaxed about it since you can't get at it for quite some time), that might suggest you are a bit heavy on cash and could invest some of it in your S&S ISA. In terms of your geographic split, it looks fine, so it would probably be a case splitting the money between the same funds in that proportion.

Traditionally, Gilts would be used to balance out the equities, but with the current low yields and potential for capital loss if interest rates rise, sticking to cash could be the most sensible option right now. You could look to add a corporate bond fund if you wanted some further diversification in your defensive assets.

Thanks, that's really helpful. You've confirmed my sneaking suspicion that I could probably justify putting a bit more into S&S. I can't realistically say that losing 60-70% would feel materially different from losing 50%. Both would be pretty annoying, but neither would keep me awake at night (I'm a heavy sleeper...), given that I can't see any reason why we'd actually need the money for a long time. Presumably if our circumstances changed such as to change my working assumption that we won't need the money before retirement, that would be the time to move money out of S&S back into cash?

masonic

Abatement wrote: »

Presumably if our circumstances changed such as to change my working assumption that we won't need the money before retirement, that would be the time to move money out of S&S back into cash?

Yes, and it's perfectly normal to revise and adjust your plans as your circumstances change. The rules of thumb around long investment horizons are to protect you from being forced to sell at a loss in the early years. This becomes less important the longer you are invested. It also doesn't mean to say you can't pull money out during favourable market conditions, and you should aim to do so in the good times if you learn of any forthcoming financial needs you may have.