How to diversify beyond shares

Diversification with bonds and commodities could be a great way to reduce risk and smooth returns.

We talk about diversification a lot; how it’s one of the best ways to reduce risk in your portfolio and why it’s important to provide smooth returns.

When we say ‘diversify your portfolio’ we usually mean spread your assets in three ways:

Geographic diversification – Where you invest around the world so that if one country or region is struggling you can expect to have exposure to other areas which are having a better time.

Sector diversification – This means spreading your money across businesses which operate in different sectors. If you have built a global portfolio across a wider range of sectors it is less likely that they will all be impacted in the same way by global events.

Asset class diversification – Buying different types of investments such as shares and bonds which react to events like a rise in interest rates in different ways.

It’s simple to grasp why spreading your money across different sectors and around the world is a good idea. Understanding the role different asset classes can play in a portfolio can be tougher to get your head around.

Shares, bonds, cash, property and commodities are examples of asset classes. When investment managers talk about assets in an investment portfolio they usually exclude property as many people often have exposure through their home and cash because it’s held as an emergency fund or to cover short term needs. This leaves us with shares, bonds and commodities.

Bonds (also known as fixed-income investments) are the traditional way to bring diversification to a portfolio of shares.

A bond is a loan to a government or business for which you receive set payments of interest every year until the bond’s maturity date. When the bond matures, the money you initially loaned is paid back to you.

Since the 1990s, the prices of shares and bonds have generally moved in opposite directions. A good year for shares has been a poor year for bonds and vice versa. This means holding a mix of both shares and bonds has been a great way to smooth returns over the long term. In periods of high inflation, as we had in 2022, the correlation between the two typically become much more aligned.

You can buy individual bonds issued by businesses or governments or a portfolio of bonds managed by an expert in a bond fund.

Commodities are raw materials and fall into three main categories; energy, metals and agriculture.

Unlike shares and bonds these assets are available in their physical form. You could choose to buy a drum of crude oil, a gold bar and a cow to create a commodity portfolio. Most investors prefer not to share their living space with livestock or anything highly flammable so choose the indirect route of commodity-focused ETCs (Exchange-Traded Commodities) which track the performance of a single commodity, such as gold or oil.

ETCs operate in a similar way to Exchange Traded Funds (ETFs) but invest in Commodities instead of a wider selection of companies and are considered higher risk because of the concentration of their focus.

Oil is a significant part of the global energy mix, used in the manufacture of many commonly used products and the most-traded commodity in the world.

The oil price is largely determined by a balance of factors including, production quotas and disruptions geopolitical tensions on the supply side, against the need to fuel industry, transportation, and infrastructure projects on the demand side.

Oil’s long-term future is unclear, there are strong drivers towards green energy and more sustainable industrial options but, as we stand today, oil has a key role in the world economy.

While you may expect the price of oil and the value of the stock market to follow similar paths, unfortunately it’s not that simple. There have even been years where one rose while the other fell. Particularly in times where inflation is increasing, commodities such as oil can help with diversification. However, the price of oil can also be very sensitive to conflicts around the world as it can affect demand and supply making it occasionally quite volatile.

Unlike oil the price of gold isn’t driven up by a need to use the material. Globally the largest use of gold is in jewellery followed by its use as an investment and reserve asset.

Investment textbooks will tell you that gold is a ‘safe haven’. That when people are anxious, they move their money from the seemingly volatile stock market to the perceived safety of gold. When stock markets fell in 2008 and 2020 gold trended upwards

While gold can be volatile in the short term, it has maintained its value over very long periods, making it a stable component in a long-term investment strategy.

Physically holding gold is much more accessible than crude oil but for simplicity and liquidity many investors look to by an ETF when adding gold to their portfolio.