Investing in several ASX stocks from several different market sectors arguably provides the minimum risk protection that all investors need. This essential investment consideration is called diversification.
Imagine having all your money invested in ASX travel shares at the start of the pandemic. Or your life savings in bank stocks when the Global Financial Crisis hit.
Is that enough said on why diversification is important?
Next question: How many ASX stocks are ideal to achieve good diversification in your portfolio?
Let's find out.
How many ASX stocks make the perfect portfolio?
Holding a number of ASX stocks from different sectors tends to smooth out your returns because it allows the sectors that do well to offset the sectors that do not in any given year.
If you have geographic diversification, meaning ASX stocks, some US shares, and some other international stocks, then you can also benefit from the economies that do better than others each year.
But investors can also go too far with diversification.
Famous United States investor Peter Lynch came up with the term 'diworsification' to highlight the risks of having your money spread too thinly across too many stocks.
This worsens your portfolio's risk-return trade-off, according to advice published on asx.com.au.
What do the experts think?
In a new article, the ASX presents the views of several market experts on how best to build a portfolio of stocks with adequate diversification.
Rachel Waterhouse, CEO of the Australian Shareholders' Association (ASA), said:
I've met with some ASA members who only own one stock and thus have no diversification, and others who own 40-50 stocks, which is too many. I've heard some members say 10-20 stocks is ideal, but there's no magic number for diversification.
Waterhouse points out that investors who choose to buy individual ASX stocks need to monitor them.
She said:
I don't think investors can properly monitor 40-50 stocks in their portfolio unless they are prepared to be stuck at a desk for 12 hours a day. Even then, there's only so many stocks that one can get their head around.
Here at The Fool, we recommend buying 15 to 25 stocks to create an adequately diversified portfolio.
Are ASX ETFs the way to go for easy portfolio diversification?
Index ETFs like the BetaShares Australia 200 ETF (ASX: A200), which tracks the S&P/ASX 200 Index (ASX: XJO), or the Vanguard Australian Shares Index ETF (ASX: VAS), which tracks the S&P/ASX 300 Index (ASX: XKO), make diversification easy for investors who don't want to research individual ASX stocks.
Some investors also choose international index ETFs like the iShares S&P 500 AUD ETF (ASX: IVV), which tracks the S&P 500 Index (SP: .INX), or the Vanguard US Total Market Shares Index ETF (ASX: VTS), which tracks the CRSP US Total Market Index (NASDAQ: CRSPTM1), which is comprised of 3,700 US stocks.
By choosing index ETFs, investors accept that they can only ever hope for average market returns less fees. But those average returns are incredibly good, just quietly.
Vanguard says the ASX All Ords has delivered an average 9.2% annual return over the past 30 years, while the S&P 500 has delivered 10% per annum over the same timeframe.
Gemma Dale, Director of SMSF and Investor Behaviour at nabtrade, says many customers buy ASX ETFs, but they do so for different reasons, depending on their age.
Dale said:
Older customers tend to invest in ETFs for exposure to international shares or other asset classes, having already built a portfolio of Australian shares through direct investing. For them, adding ETFs is about achieving asset allocation in portfolios.
Younger nabtrade customers are increasingly investing for the first time through ETFs. Interestingly, a great proportion of younger nabtrade customers now start with an ETF over the S&P/ASX 200 index and then build their portfolio up slowly from there.
A warning on index funds tracking ASX 200 stocks
While index investing certainly provides diversification, some indexes have heavy sector concentration.
The ASX 200 is one of them, with financial and resources stocks comprising 52% of the index on 30 June.
So, this is something to be aware of, but as Betashares investment strategist Tom Wickenden points out, you can also offset it.
Wickenden says the Betashares Nasdaq 100 ETF (ASX: NDQ), which tracks the NASDAQ-100 Index (NASDAQ: NDX), is particularly complementary to ASX 200 index ETFs.
This is because the NASDAQ 100 and ASX 200 have opposite sector weightings.
The ASX 200 comprises 30.6% financial shares, 22.7% materials shares, and only 3.2% tech stocks. In contrast, the NDQ ETF has only 1.5% materials shares, 0.5% financial shares, and 50.5% tech stocks.
Adam DeSanctis, Head of ETF Capital Markets Asia-Pacific at Vanguard Australia, says there are four key principles for portfolio diversification: goals, balance, cost, and discipline.
He says investors need clearly stated goals, balanced asset allocation appropriate to those goals, a focus on minimising portfolio costs, and the discipline to maintain their investment approach.
What other types of diversification are possible?
There are other types of diversification offered by ASX ETFs besides sector and geographical.
For example, investors can choose ETFs that cater to specific thematics, such as environmental, social, and corporate governance (ESG), with offerings such as the BetaShares Global Sustainability Leaders ETF (ASX: ETHI).
Investors can also choose ETFs that focus on types of businesses, such as those with major competitive advantages. An example of this is the VanEck Morningstar Wide Moat AUD ETF (ASX: MOAT).
