No doubt you have heard the saying about not putting all your eggs in one basket.
For investors, this is one of the most important things to keep in mind. It is crucial to your investment growth and protection. You need to diversify.
You may be asking why diversify if you know what you want in terms of investment and you’re comfortable with what you have anyway.
So let’s look at some of the key reasons why you need to diversify your portfolio:
- Diversification allows you to capture investment opportunities of different market cycles
Markets move up, down and sideways. Each cycle presents different opportunities. Many investors were caught out when mining stocks went out of favour.
The same thing happened during the dotcom bubble. If all of your investments are in assets that are falling in price, you may have to endure the pain of a drawdown (and potential losses) before values rise again.
Diversifying into assets that are at different stages of the cycle will help to smooth out your returns, helping you to avoid the deepest drawndowns.
- Diversification gives you exposure to a broader range of opportunities
Many investors place their hard-earned funds into the assets they are most familiar with.
For many this means property and a handful of big-name companies listed on the local stock exchange. They are missing out on moves that may be taking place in commodities or interest rate markets or even in industries that are not well represented on the Australian exchange.
With diversification, you can have a portion of your portfolio invested in a broad range of asset classes so that you have the opportunity to participate in a broader range of market moves.
- Diversification enhances your risk management strategy
All successful investors count on a risk management strategy that ensures capital protection and preservation. As another market saying goes: “You need to preserve your capital to be able to invest for another day.”
Diversification – allocating a certain percentage of your investment capital to different assets – is an effective way to protect your capital, or at least a percentage of it, when some of your investments suffer from falling prices.
While most investors know of the need to diversify, some are not confident about doing it.
Some who lack the time and resources to review their investments on a regular basis may end up holding the same stocks for longer than necessary.
Here are the top three ways you can diversify your portfolio:
- By trading and investing in different asset classes – shares, exchange traded funds, property
Australia ranks high among the developed countries in terms of stock ownership.
According to the 2017 ASX survey of share ownership, 37% of the country’s adult population – an estimated 6.9 million people – invest in a securities exchange; 31% hold shares, 7% hold derivatives and another 11% hold other on-exchange investment assets.
There are also a significant number of Australians who invest in property. According to a recent CoreLogic property investment report, there are about 2.03 million individual property investors in the country.
By combining different asset classes in your portfolio, you can be assured of the benefits of diversification as you go through the market cycles.
- By investing in different industries/sectors
It may be hard to believe but some investors get emotionally attached to certain stocks. There are also investors who hold only one or two stocks, which could be risky if the majority of their capital is tied to these limited investments.
If you invest in different industries and sectors, you have a better chance of capturing investment opportunities in several areas. It also gives you a certain level of protection when one sector enters a downward trend while the others are trending higher.
The thing to remember here is that different industries move in different directions. Some are more positively or negatively correlated than others.
As an investor, you want to be in sectors that are not all closely correlated to one another, so a portion of your investment can still be protected while others are going through a rough patch.
- By investing in international stockmarkets
Australian investors are also known to have one of the highest levels of home country bias – the tendency to buy and hold shares from their domestic market. This bias is one of the biggest factors that can limit your investment potential.
If you are investing only in the Australian stockmarket, which represents less than 3% of the world’s total market capitalisation, you are missing out on massive opportunities.
While Australia is a mature investment market and home to some of the world’s largest companies – for example, BHP Billiton and Rio Tinto – the undeniable fact is there are numerous investment opportunities around the globe.
You need not look far to see that some of the household names – Apple, Amazon and Facebook – are listed on exchanges outside Australia.
By investing in these technology and social media companies, you are giving your portfolio a much-needed boost.