One of the first lessons taught to new investors is the importance of diversification. That’s because it significantly reduces the amount of company-specific risk being taken while also allowing the investor an opportunity to benefit from the share price rises of different stocks in multiple sectors.
It could be argued that diversification is essentially an admission that things do not always go perfectly to plan and that different sectors and industries perform well (or not so well) at different points in the economic cycle. And as history has shown, it can help to not only smooth out returns over a long period, but also improve returns as investors tap into a wider range of stocks with above-average growth potential.
While most investors do diversify, the FTSE 100 remains a relatively poorly diversified index. That’s because it’s dominated by financial services and resources companies. Clearly, the former plays a major role in the UK economy, so the high volume of stocks within that sector is perhaps understandable. However, in the case of resources companies, the UK economy has a relatively small offering and yet 17.3% of the FTSE 100 is made up of such companies.
Clearly, this was beneficial during the resources boom. In fact, back when oil was well above $100 per barrel and mining stocks were booming, the FTSE 100 undoubtedly gained a huge benefit from having a high proportion of its stocks from those industries. However, just as having a concentrated portfolio can mean exceptional profits, it can also lead to huge losses and in the last year the FTSE 100 has fallen by 6% while other indices have performed much better.
Similarly, the FTSE 100’s weighting towards financial services has also been a significant cause of its rise of just 7% in the last five years. Today, the proportion of the index in financial services companies stands at 21.2% and with banks, insurers and other financial services stocks having endured a challenging recent past, their performance has weighed the FTSE 100 down.
Of course, the US equivalent of the FTSE 100 – the S&P 500 – has a more diversified make-up of constituents. For example, the materials and energy sectors constitute 9.9% of the index, while financials make up 16.6% of its total weight. As such, while financials and resources companies account for 38.5% of the FTSE 100’s total returns, the figure is a third lower for the S&P 500. This has helped the US index to post a rise of 68% over the last five years since it has simply had lower exposure to sectors that have generally endured turbulent periods.
Looking ahead, resources and financial services could prove to be star sectors in 2016 and beyond. Thus they could boost the FTSE 100’s returns and make a lack of diversification appear to be a benefit rather than a weakness for the UK’s main index. However, as has been the case in previous years, they could equally weigh down the FTSE 100’s performance and cause it to underperform other major indices over the medium term.