Shield your portfolio from risks

But how do you know which ones to buy for your portfolio and which ones to ignore?

Well, there's a simple tool to help you assess whether your portfolio is well or more risky than you think.

Diversification entails investing in a range of different assets. It reduces risk by ensuring that no single event or situation poses a large threat to your portfolio.

Though a greater number of stocks will usually afford you greater diversification, it's no guarantee. Rather, understanding correlation is crucial to diversifying intelligently.

Two businesses are positively correlated when, if one is doing well, the other is also likely to be doing well. Likewise, if one is struggling, so is the other.

If two businesses are uncorrelated, there will be no relationship between their respective performances.

And if they're negatively correlated, when one is doing well, the other is likely to be doing badly.

When evaluating correlation, concentrate on the relationship between businesses' respective earnings power rather than their share price movements. Although prices tend to move together during bull and bear markets, that doesn't mean all businesses are correlated.

Sensible diversification means avoiding too many positive correlations. That way, only small parts of your portfolio will be exposed to any individual risks.

Businesses are correlated when they're affected by macro-economic developments or other events in the same way as other businesses.

In practice, stocks in the same industry are usually correlated. Retailers, for example, are affected by retail conditions and consumer sentiment in much the same way.

Geography also plays a big role. Businesses that are sensitive to economic conditions in the same location will be correlated.

Owning too many businesses in the same industries, or operating in the same region, can lead to a portfolio with poor diversification.

The way to test for correlation in your portfolio is to imagine many different scenarios and their likely effects on your stocks (positive, negative, or little effect) and to see which ones show similarities.

To help, we've created a sample portfolio from our current buy recommendations. For brevity, the columns above represent only four possible eventualities but you can come up with as many as you like.

These scenarios are macro-economic in focus. Stock-specific risks are not represented.

This portfolio has obvious problems. First, financials weigh too heavily. This is shown by the ominous arrows in the "Financial market meltdown" column.

Second, a huge chunk of this portfolio is correlated to the Australian dollar. If the dollar falls (which we believe it will), it would be fantastic for this portfolio.

A continued appreciation, however, poses a substantial risk.

The portfolio is better diversified in respect of oil prices.

A higher oil price might reduce passengers through MAp Group's airports but this would be offset by the higher prices Santos would receive for its oil and gas.

Likewise, though higher interest rates would increase interest costs for the indebted businesses, QBE and Computershare would benefit from higher fixed-interest returns on their float.

Investing entails risk but there's no reason to shoulder more than necessary and there's no excuse not to understand the types of exposure.

Apply this risk-matrix process to your portfolio to see whether it's diversified properly. If not, now is the time to act.