What is diversification?
Regardless of how long you've been investing, chances are you've heard of diversification. So, what is it?
Put simply, diversification means not putting all your eggs in one basket. Applied to the share market, this means spreading investment funds across a range of ASX shares rather than putting all your money into a small number of companies.
By diversifying your portfolio, you spread your risk — meaning you shouldn't get wiped out if one or two investments fail!
According to Nobel prize winner Harry Markowitz, diversification is the only "free lunch" in investing. This is because diversification can help minimise risks for a given level of return.
It is important to understand that all types of investing involve risk. Investors are compensated for taking risk via the 'risk premium'. This is the excess return on assets above that of 'risk-free' assets, such as cash.
The rationale behind diversification is that a portfolio constructed using a broad mix of holdings will provide higher long-term returns and lower risk than a single shareholding or a small number of stocks.
This is because diversification can reduce unsystematic risk in a portfolio, which is risk unique to specific companies or industries.
Modern portfolio theory, which demonstrates how investors can construct their portfolios to maximise return for a given level of risk, is based on this principle.
Most investors would like a certain level of return but would prefer to limit the risk associated with their portfolio. Diversification plays an essential role in helping investors achieve this.
The ideal number of shares to own
So, how many ASX shares do you need to own to be sufficiently diversified?
There is no firm answer to this question, but most experts agree that 15 to 25 stocks will provide sufficient diversification for an individual investor.
The impact of diversification depends not just on how many listed companies you own but also on the type of companies you own.
Diversification works best when holdings are spread across different sectors of the economy.
There are 11 sectors represented on the ASX. They are energy, materials, industrials, consumer discretionary, consumer staples, healthcare, financials, information technology, communication services, utilities and real estate.
Investors can also diversify across different sizes of companies by choosing a mix of large-cap, mid and small-cap shares. 'Cap' refers to market capitalisation, the total value of a listed company calculated by multiplying the number of shares on issue by the share price.
(A sprinkle of Foolish guidance, though — if you're a new investor, it's a good idea to start with large caps as you build up your portfolio. These are typically more established companies that are more likely to have a proven track record; thus, the risk profile to investors is lower.)
You can also diversify across geographies by investing in publicly listed companies on other stock exchanges outside Australia.
There is much more to diversification than simply holding a certain number of shares. You also need to consider your investment goals and time horizon, current market conditions, and your ability to keep up to date with market news.
Diversification works because the return on assets is less than perfectly correlated. Therefore, to maximise diversification benefits, investors should construct their portfolios using a range of assets that perform differently under varying market conditions.
Diversification across industry sectors
To maximise the benefits of diversification, investors should seek to diversify across the 11 market sectors and the hundreds of industries within them. This is because industries tend to perform differently over time.
For example, when commodity prices are high, ASX shares in the resources industry tend to perform well. Likewise, when there was high demand at supermarkets during the COVID-19 pandemic in 2020, ASX shares in the food and staples retailing industry benefitted.
However, industries do not always perform well, which is why you need a mix in your portfolio. Buying several ASX stocks within a single sector or two will leave you susceptible to industry-wide events and impacts.
For example, if your portfolio held only ASX travel shares when COVID-19 hit, you would have been highly exposed to the resulting global downturn. The majority of your stocks would have gone into freefall at the same time. Similarly, a portfolio that solely comprised tech shares would have been hammered during the dot.com crash at the turn of the century.
Australian shares investors can easily diversify across industries because there are more than 2,000 companies listed on the ASX.
Some industries, such as retailing and technology, tend to do better when the economy is performing well. Other industries, such as healthcare, tend to be more defensive and thus provide a buffer during economic downturns.
The importance of diversification becomes apparent when you consider that the economy continually moves through cycles. These provide shifting headwinds and tailwinds for different industries over time.
Diversification across asset classes
Different asset classes have other risk and return characteristics and tend to perform well at different times. This means you can lower the overall risk of your broader investment portfolio by spreading your money across asset classes.
Property is a popular investment in Australia, but this asset class is not limited to bricks and mortar. The ASX has its own real estate sector containing scores of real estate investment trusts (REITs) that can give investors property exposure.
REITs are publicly traded trusts that own or operate income-producing properties such as offices, warehouses, and shopping centres.
We typically consider gold a defensive asset, as it tends to hold its value during downturns in the share market. Cash and bonds are also defensive assets because they're less likely to lose money, but expected returns are lower over the long term than growth assets.
Growth assets, such as ASX shares, have higher expected returns, but the risk of losing money is also higher — especially in the short term.
Cryptocurrencies are a relatively recent asset class. There has been exponential growth in the prices of many cryptocurrencies over the past few years. But prices are also highly volatile, making cryptocurrencies a higher-risk investment.