Vertical diversification is when your investment portfolio is spread across different types of assets.
Cash, government bonds, corporate bonds, property and shares can each be expected to behave slightly differently and so produce different returns, as circumstances change.
For instance, government bonds may soar when stock markets crash, because frightened investors sell their shares to seek the security of government debt.
For an illustration of vertical diversification, consider three portfolios invested across just two asset classes, cash and shares:
- Boring Portfolio: 100% cash. 0% shares
- Racy Portfolio: 0% cash. 100% shares
- Middle of the Road Portfolio: 50% cash. 50% shares
Let’s imagine the shares chosen for the portfolios are all dreadful picks, and the shares’ value falls to zero:
- The value of the Racy Portfolio, which is all shares, obviously falls to zero.
- The Boring Portfolio, which is 100% in cash, retains all its value.
- The Middle of the Road Portfolio produces a middling result, retaining 50% of its value.
Suppose instead the shares doubled:
- The Boring Portfolio doesn’t benefit, but it doesn’t lose money either.
- The Racy portfolio doubles in value.
- The Middle of the Road Portfolio also benefits. The cash holding again retains all its value, while its 50% allocation to shares doubles, meaning the portfolio enjoys 50% of the gain of the Racy Portfolio.
In the real world, of course, returns from broadly spread mainstream assets will seldom fall to zero. Also, I’ve ignored interest on cash deposits, which over time makes cash useful as more than just a store of value.
But the example does show clearly how rewards are traded off to lessen volatility when employing vertical diversification.
Vertical diversification can be extended to other types of securities, particularly fixed-rate and inflation-linked government bonds, to produce a diversified portfolio that aims to match your personal risk/return appetite.