The turbulence that has rocked global sharemarkets in recent weeks has highlighted the importance of maintaining a diversified share portfolio, which allows the weaknesses and risks that one company possesses can be offset by the strengths and potential of others.
Investors' portfolios plunged in value as the US government impasse continued without definite signs of a resolution being reached. The S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) fell as low as 5118.9 points after having hit a fresh five-year high of 5307.1 points just one week prior whilst the US Dow Jones fell 6% in the last three weeks.
Whilst it is the nature of sharemarkets to experience such turbulence (there will always be risks involved), diversification can substantially reduce the level of risk being undertaken. Here are three ways to diversify your share portfolio:
1. Expose your portfolio to different industries: Often, stocks in a single industry will behave in a similar fashion to other stocks in that industry. Each of the stocks in the industry may rise on the release of good news (all other things being equal), but they will generally also fall together on the release of bad news. To spread the level of risk, it is wise to invest in different sectors that are less likely to move in tandem with one another.
As an example, if you were to invest in Myer (ASX: MYR) to take advantage of a recovering retail sector, you might also expose yourself to the telecommunications industry through Vocus Communiations (ASX: VOC) rather than purchasing another retailer.
2. Diversify by company size: Whilst some investors with a low risk tolerance will only expose themselves to the 'defensive' stocks, others will predominantly focus on growth prospects.
It's a good idea to maintain a balance of these — well-established companies such as Telstra (ASX: TLS) or Wesfarmers (ASX: WES) can make up a strong foundation for your portfolio, whilst smaller companies with promising futures, such as Silver Chef (ASX: SIV) or 1300 Smiles (ASX: ONT), could reward you with greater gains in the long-term.
3. Look beyond Australia: The Australian sharemarket is a good starting point, but it only represents a tiny 2% of global stock markets! Meanwhile, it is heavily concentrated in just two sectors – finance and mining. If either of these experience a downfall, then most of the stocks on the ASX will follow.
By venturing into foreign stocks, significantly greater opportunities can arise. For instance, you would be able to invest in some of the strongest companies in the world, such as Google (Nasdaq: GOOG) or Apple (Nasdaq: AAPL), which have delivered returns of 352% and 1,350% since the beginning of 2005, respectively.
It is argued that to receive the greatest benefits from a diversified portfolio, as many as 20 companies should be owned. If you were looking for other great companies to invest your hard earned dollars, then look no further than our #1 dividend-paying stock. Discover The Motley Fool's favourite income idea for 2013-2014 in our brand-new, FREE research report, including a full investment analysis! Simply click here for your FREE copy of "The Motley Fool's Top Dividend Stock for 2013-2014."
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Motley Fool contributor Ryan Newman owns shares in Silver Chef.