The importance of 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’re spreading 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 an element of risk. Investors are compensated for taking risk via the ‘risk premium’, being 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 small number of holdings or a single shareholding.
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 portfolios can be constructed 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 important 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 15 to 25 stocks will provide sufficient diversification for an individual investor.
It is important to remember that the impact of diversification depends not just on how many listed companies you own, but also the types 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, mid and small-cap shares. ‘Cap’ refers to market capitalisation, which is the total value of a listed company calculated by multiplying the number of shares on issue with the share price.
(A sprinkle of Foolish guidance though – if you’re a new investor, it could be a good idea to start with large caps for now as you build up your portfolio. These are typically more established companies that are more likely to have a proven track record and 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, in order to maximise diversification benefits, investors should look to 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 and within 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 (within the ASX materials sector) 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 (part of the ASX consumer staples sector) benefitted.
However, industries do not perform well all the time, which is why you need a mix of them in your portfolio. Buying several stocks within a single industry or two will leave you susceptible to industry-wide events and impacts.
For example, if you held a portfolio of only ASX travel shares when coronavirus hit, you would have been highly exposed to the global downturn that resulted. The majority of your stocks would have gone into freefall at the same time. Similarly, a portfolio of only tech shares would have been hammered during the dot.com crash at the turn of the century.
Diversification across industries is easy for Australian shares investors 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 clear when you consider that the economy continually moves through cycles, which provide shifting headwinds and tailwinds for different industries over time.
Diversification across asset classes
Different asset classes have different risk and return characteristics, and they 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.
Similarly, gold investors are not limited to buying and holding physical gold. You can also gain exposure to the gold price by buying shares in gold mining companies listed on the ASX.
Gold is generally considered 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 compared to 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 new asset class. There has been exponential growth in the prices of many cryptocurrencies over the past few years, but prices are also highly volatile. This makes cryptocurrencies a higher risk investment.