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Spreading out the risk: Five ways to diversify an equities portfolio
Ask any successful fund manager or investor how they built their wealth, and they’ll say portfolio diversification played a big part. Put simply, diversification – the lifeblood of investing – involves spreading your money across multiple investments. Put even simpler: don’t put all your eggs in one basket.
Diversification is used to manage risk, reduce volatility and smooth out portfolio returns. Interestingly enough, too much diversification can also be a bad thing: the more investments in a trading account, the less influence each investment has, which can make it harder for the portfolio to outperform the market. Nonetheless, diversification is a key strategy to build long-term, sustainable wealth – across not just shares, but also assets like property and cash.
Diversification options in the stock market are about as widespread as the number of thematic exchange-traded funds (ETFs) proliferating each year. To keep it eggs-and-baskets simple, below are five strategies for diversifying a share portfolio, and why it’s so important.
Diversification across the ASX
Most investors would have some understanding of how to build a diverse portfolio of ASX shares. Holding a “basket” of ASX shares mitigates exposure to any single stock and decreases the risk of significant portfolio losses that might accompany any negative news tied to that stock. And as unlikely as it might seem, all shares have the potential to go to zero.
There is no ‘magic’ number of stocks to hold to diversify a portfolio – this will vary from one investor to the next and depend on the type of stocks chosen and the size of the portfolio. The average Selfwealth member owns fewer than 10 different holdings, but many investment professionals suggest 15 to 20 different stocks can help diversify a portfolio.
Diversification across regions and markets
Australian investors often focus on ASX stocks because of their familiarity and ease of access, among other factors. However, Australia represents just 2 per cent of all global market opportunities, meaning there is a wealth of opportunity accessing international shares.
If investing directly in international stocks seems daunting, many ASX-listed ETFs provide exposure to international shares. ETFs are a simple, cost-effective way to instantly diversify a portfolio through exposure to a basket of stocks through one investment. Some ETFs even protect against foreign-exchange movements.
Australia is also home to numerous large companies with global operations in markets with differing economic conditions; they may even have exposure to the US dollar. These stocks provide a third option for portfolio diversification by region.
Diversification by industry
At first glance, with over 2,000 stocks available to invest in, the ASX appears to offer a diverse range of shares. But a closer look shows about 60 per cent of the ASX 200 is weighted towards companies in the materials, financials and real estate sectors. The local tech sector accounts for less than 4 per cent of the weight of the ASX 200.
Investors should therefore look at the industry exposure across the stocks they own. Some of these industries go through cycles; some segments also take off at certain times, driven by external factors or emerging trends. Consider the rise of battery metals stocks in response to growing uptake of electric vehicles.
Diversification by investment theme or goal
Many investors like to focus on a particular investment goal, such as capital growth or income.
Each has its own merit, and targeting both can also help to diversify a portfolio. Investing in growth stocks can yield long-term capital appreciation, while stable blue-chip dividend stocks can provide ongoing income.
Another growing theme is environmental, social and governance (ESG) investing, with an extensive list of ETFs offering exposure to a basket of ‘ethical’ and ‘responsible’ stocks. Selfwealth features an ESG rating tool to review stocks against an expansive framework of ESG criteria, including an all-important ‘controversy’ score.
Diversification over time
Many investors add portfolio diversification over time through dollar-cost averaging (DCA), or buying shares in a certain stock at set intervals and for the same dollar amount each time. Making one large purchase of a particular stock, also called lump sum investing, places more weight on the share price of that trade. Staggering buying activity via dollar cost averaging allows an investor to spread that exposure across time, and employing a DCA strategy over many periods has been shown to outperform even buying the dip (see chart).
Although diversification can potentially cap returns, it is important to manage risk and aim for consistent returns. Low diversification can expose an investor to unnecessary risk and magnify losses.
Each of the above strategies will help diversify a portfolio in different ways; no single approach is necessarily better than another. However, using several diversification strategies in unison offers sound protection against portfolio volatility, which is helpful for achieving sustainable long-term returns.
