You’ll need to invest in about 20 stocks to consider yourself diversified, writes Zoe Fielding.
Share investors typically make money when the companies whose stocks they own perform well. But even strong companies periodically face challenges that reduce their ability to pay dividends and lower their share price.
Some people are prepared to ride out the ups and downs in investment returns, but others – especially those approaching retirement – need more consistent results.
Diversifying a share portfolio can help smooth the volatility of returns and minimise the effect of losses in individual investments, as one stock’s strong performance may offset another’s weakness, says Thirdview director Peter Foley.
“You [generally] want a combination of income and growth-producing stocks,” Foley says.
He says it is best practice to invest across different regions and “different countries within regions, different sectors within countries, and in both defensive versus aggressive stocks”.
This can commonly be best achieved by investing in groups of shares, such as an index fund, rather than picking and choosing on your own.
The Chartist head of trading and research Nick Radge says investors should aim to hold stocks in a range of market segments.
“This doesn’t just relate to sectors such as gold or banks, it also extends to large caps and small caps,” he says. “Broadly speaking, these will rise and fall together but there can be extended periods where they diverge.”
Over the past 12 months, for example, Australian large-cap stocks underperformed small caps, making it an unrewarding period for investors holding only conservative companies. However, through 2014 and 2015, large caps performed well as international investors sought companies with high-dividend yields.
Don’t be blindsided
Investors who hold only one or two stocks may find that company-specific risks, such as poor management decisions or the emergence of new, competing technologies, badly damage their portfolios, says Pride Advice financial adviser Brett Schatto.
“You don’t know the future so you can’t say that just because a company is successful today it’s going to be successful in 20 years,” Schatto says.
But many investors don’t diversify.
Investors often fall in love with a specific stock and become blinded to its shortcomings. “Sometimes this is so strong it can be an ‘all or nothing’ position,” says Radge.
Another reason is that it can simply be difficult to build a well-balanced portfolio.
Professional advisers can help construct a portfolio to achieve investors’ objectives while keeping risk at an acceptable level.
Radge cites studies suggesting a portfolio of 15 to 20 stocks generally provides the optimal balance between risk and return. His business uses 20 positions across its portfolios, allocating assets equally to each.
For Foley, about 20 to 30 stocks is the “sweet spot” for diversifying a portfolio. With more stocks, the additional research, transaction and management costs begin to outweigh the risk reduction benefits. “You can be over-diversified,” he says.
Investors may be able to achieve a balanced portfolio with fewer stocks, depending on what they buy and how the portfolio is structured, says Schatto.
“If you are holding a listed investment company, you’ve got some diversification there. If you hold eight to 12 stocks that might give you a good diversification across the Australian share market,” he says.
Diversifying via index funds or ETFs
Some investors employ what’s known as a core-satellite approach, investing 50 per cent to 80 per cent of their capital in a diversified listed investment company, index fund or exchange traded fund (ETF) and allocating the rest to just two or three stocks.
Index funds and ETFs can offer a low-cost means of gaining diversified exposure to the sharemarket. This may be especially useful for people with small amounts to invest.
The funds track a group of assets that have similar characteristics, known as an index. Their managers do not research individual investments but rather buy all or most of those securities that meet the index criteria. ETFs provide exposure to assets they're based (though they're not always directly invested in the asset, instead tracking the movement of the asset, such as a commodity, a currency or international sharemarket).
Such funds can focus on specific sectors, investment themes and geographic areas. They can provide access to a broader range of investments than would otherwise be impractical such as global sharemarkets, baskets of soft commodities and foreign currencies.
The products do have their drawbacks. In some cases fees, taxes and other costs may cause them to underperform their reference index, Radge says.
Pricing methods may also mean investors pay more to buy than the underlying assets are worth, and sell for less, he adds.
“Currency risks can also occur if the ETF invests in international markets and doesn’t hedge that exposure. Even if the ETF performs, a loss may occur due to adverse movements in the Australian dollar,” Radge says.