What is diversification?
Diversification is the idea that by combining your investments into a portfolio you can minimise the risk associated with the overall portfolio. The easiest way I can explain it is with the use of an example:
If you buy two factories both producing blue cheese, then, months later, blue cheese is found to cause disgusting body odour, your factories will be worth next to nothing. But if you bought one blue cheese factory and one camembert cheese factory, your downside is reduced.
The idea is to add investments that increase your return potential but reduce risk.
The same concept can be applied to a share portfolio (or any portfolio, for that matter). Instead of cheese factories, you can combine shares in a prudent way.
It’s been shown that around 30 shares is enough to adequately remove most of the risk associated with a share portfolio (note: it will still have some risk, of course). I recently wrote about the concept in detail, here.
5 shares to diversify a portfolio
The mathematical concepts behind diversification can get a little confusing at times. But it comes down to spreading the risks yet keeping the upside potential. You can do that by buying shares in great companies operating across different industries, product groups, services, or geographies.
Here are five quite different ASX-listed businesses to consider.
Macquarie Group is a $30 billion investment bank. Unlike a standard retail bank such as National Australia Bank Ltd. (ASX: NAB) or Commonwealth Bank of Australia (ASX: CBA), Macquarie offers more corporate-style finance services like investment research and asset finance. By design, the bank’s profits are subject to movements in financial markets. However, over the long-term, its returns have been impressive.
Formally Burson Group, Bapcor is the owner of Burson Auto Parts and Autobarn. Its products are delivered to some of the biggest franchise mechanics across Australia every day. Some analysts believe that because Burson offers products for aftermarket repairs, its shares have defensive qualities. Meaning, in a recession, people are less likely to buy a new car but repair their old vehicle. If that’s true, Bapcor shares could offer some protection in a downturn.
TPG is a household name in Australian broadband. It is also pushing into mobiles and continues to make a significant investment in infrastructure assets, such as fibre cabling and an international expansion.
Blackmores is a consumer favourite. The company produces vitamins and infant formula, among other products. One of its core strategies is to crack the large Chinese consumer market.
The addition of Capilano to a portfolio with loads of shares in Blackmores probably wouldn’t have the diversification benefits it otherwise could. However, Capilano is a smaller company operating in the somewhat niche honey market. Given management’s track record and the long-term outlook for its business, I think it deserves a spot on watch lists.
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The Motley Fool Australia owns shares of Bapcor and Capilano Honey Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
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