Ask many successful fund managers and investors how they managed to build their wealth, and they’ll likely tell you that portfolio diversification played a fundamental role. In its simplest form, diversification involves allocating capital across multiple investments in order to manage your risk.
One of the key reasons to employ diversification in your share portfolio is to reduce volatility and smooth out returns. With that said, too much diversification can also act as a handbrake to portfolio growth or make it more difficult to outperform the market. This is particularly the case if your trading account consists of a large number of investments, whereby you are effectively running a ‘mini-index’.
Nonetheless, investment diversification remains a key strategy to build long-term sustainable wealth. While diversification is often viewed as a broad focus extending to other asset classes like property and cash, when it comes to the stock market, there are multiple ways to achieve portfolio diversification. Here we discuss five key approaches you can utilise to diversify your investment portfolio.
Diversification across the ASX
Most investors would be familiar with the notion of portfolio diversification within an asset class. In this instance, ASX shares. This involves holding a basket of shares within your SelfWealth online trading account. Putting all your capital into one stock is a high-risk scenario, even if it does come with the prospect of higher returns.
However, if you mitigate your exposure to any single stock, you decrease the risk of significant portfolio losses that would accompany any adverse news or events tied to that investment. After all, as unlikely as it might seem, all shares have the potential to go to zero, and there are plenty of well-known case studies, including household names such as Ten and Virgin Australia.
There is no perfect number when it comes to the number of different stocks to achieve diversification. This will vary from one investor to the next, the nature of the stocks you pick, as well as the size of your portfolio. The average SelfWealth member owns less than 10 different holdings, however, many investment professionals suggest that a higher amount of around 15-20 different holdings should help diversify your portfolio.
Diversification across regions and markets
There are three approaches to diversification by geography, and thanks to SelfWealth’s US share trading platform, you now have access to invest in thousands of stocks from across the globe.
Australian investors often get into the habit of focusing on local stocks listed on the ASX because of their familiarity and ease of access, among other factors. However, Australia represents just 2% of all global market opportunities, which means there is a wealth of opportunity out there in terms of international stocks. Not only is the US stock market the largest in the world, but there are a number of benefits of investing in US shares.
Meanwhile, if investing directly in US stocks seems daunting, a growing chorus of ASX ETFs provide exposure to international companies, providing a simple, cost-effective diversification tool. These ETFs provide exposure to a basket of stocks through one investment, with some options even providing currency hedging. Investing in an ETF focusing on international shares will instantly diversify your trading account.
Lastly, do keep in mind that Australia is home to numerous large companies with successful global operations. These companies will typically operate in markets where economic conditions differ to that of Australia, often with exposure to the US dollar, thereby affording investors diversified exposure to regional markets.
Diversification by industry
Diversification by industry tackles one of the common gripes that many investors have regarding the highly concentrated ASX. At first glance, with over 2000 stocks available to trade, the local market appears to offer a diverse range of shares.
However, upon closer inspection, approximately 55% of the ASX 200 is weighted towards companies in the materials, financials and real estate sectors. Despite the soaring popularity of tech stocks since the start of the pandemic, the IT sector still accounts for less than 5% of the weight of the ASX 200.
In order to diversify your portfolio you should take note of the industry exposure across the stocks you own. Many investment professionals eyeing diversification try to gain exposure to a wide number of sectors or industries. Some of these industries go through cycles, including typical cyclical stocks across commodities like iron ore and oil, as well as ‘newer’ segments over the years such as infant formula, medicinal marijuana, cobalt, lithium, and buy-now pay-later, which have been spurred by popularity.
Diversification by investment theme
Many investors like to focus on a particular investment theme, be it capital growth or income. Each approach has its own merit, however, targeting both can also serve as another means to diversify your trading account. Investing in growth stocks can yield long-term capital appreciation, while stable blue-chip dividend stocks can offer ongoing returns, provided you identify shares paying sustainable dividends.
When market volatility emerges, it is often high-growth stocks that are hit hardest. On the other hand, when the market rallies, these stocks tend to outperform. There are some shares offering exposure to both themes, but it is no easy feat to spot these companies.
In recent times, and especially amid the backdrop of the pandemic, one emerging theme that has grown in popularity is ESG investing. Today there is an extensive list of ETFs that tap into this investment theme, offering exposure to a wide basket of ‘ethical’ and ‘responsible’ stocks. Beyond that, SelfWealth now features an ESG rating tool to help investors review stocks against an expansive framework of ESG considerations.
Diversification over time
Last but not least, many investors already take advantage of investment timing to diversify their portfolio, even if they are not aware of it. This is because of the concept called dollar cost averaging, which is a strategy involving consistent stock purchases at set intervals. If you make a large investment in a stock through just one transaction, you establish a cost base that becomes more difficult to sway, even if the share price declines by a modest amount.
Investors who use dollar cost averaging inherently manage their exposure through skewed buying activity. As each purchase is for the same dollar amount, you end up buying a higher volume of shares in the company when that stock is trading at a lower price, and a smaller volume of shares when the price is higher. This approach is designed to help reduce risk by leveraging the natural variances and fluctuations in the market, effectively affording you another form of portfolio diversification.
Why diversification remains so important
Although diversification has the potential to limit your returns, there is a compelling argument to say that it is more pertinent for investors to manage risk and aim for consistent returns. A portfolio with low diversification can expose you to unnecessary risk and potentially magnify your losses.
Each of the diversification approaches discussed in this guide will help you diversify your share portfolio in different ways. No single approach is necessarily better than any other, and the decision will ultimately depend on your investment goals and risk appetite. However, a holistic approach involving various diversification strategies offers sound protection against portfolio volatility, which is helpful to achieve sustainable long-term returns.
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