Financial experts frequently say that a balanced, diversified investment portfolio is the key to building long-term wealth. But what does a diversified portfolio really mean? Could you be diversifying your portfolio the wrong way?
Why diversification matters
Diversification is one of the most effective risk management techniques available to investors. At its core, diversification is simply not putting all your eggs in one basket. Or as the experts will say, investing in different assets that react differently to the same event (like a drop in oil prices for instance) so that you get better risk-adjusted returns.
If your portfolio contained just a few oil and gas stocks, the oil price drop will cause their share prices to fall, dragging down your portfolio value. But if you were invested in multiple asset classes across different sectors and geographies, your portfolio will be less affected even if your oil and gas assets underperform because they will all have different correlations with each other.
What a diversified asset allocation looks like
Correlation is measured on a scale of -1.0 to +1.0. When building a diversified portfolio, you want to include assets that have no or low correlation with each other. A correlation of 0 means that the price movement of one asset does not affect the price of the other i.e. the two assets are uncorrelated. A high correlation (which tends to +1.0) means that prices move together in the same direction while a low correlation (which tends to -1.0) means that prices move in opposite directions.
In real life, it is very difficult to find a pair of assets that is perfectly uncorrelated. But generally, stocks and bonds are known to have a low correlation: when stock prices go up, bond values tend to go down. That’s why all portfolios should at minimum have a mix of both stocks and bonds.
But for optimal risk diversification, consider adding alternative investments such as commodities too. Commodities – precious metals, energy, agricultural products – tend to have a low to negative correlation with stocks and bonds. To further protect your portfolio during times of market uncertainty, you can also add gold to your portfolio. Amidst worries of a global economic slowdown, gold has emerged as a safe haven asset with its price surging over the past weeks.
Diversification pitfalls to avoid
Some investors think that owning 50 or even 100 different stocks gives them a well-diversified portfolio. That’s not necessarily true. If you invest in 50 stocks but they are all from the same country and sector, you’re not truly diversified because they are likely to be highly correlated. Think about the dot-com bust in 2001. If your portfolio had consisted solely of dot-com stocks, chances are, you would have lost the majority of your investments during the crash.
As you relook your asset allocation, steer clear of these three other diversification mistakes.
1: Not diversifying within asset classes
You know you should be investing in a mix of different asset classes such as stocks, bonds and commodities. But that’s not all. You also need to diversify your investments within these asset classes. When investing in stocks, that could mean investing in large cap, mid cap and small cap stocks, or stocks from diverse sectors such as healthcare, energy, consumer goods and more. The same is true with bonds. You should purchase different types of bonds (such as government bonds and corporate bonds), with different maturities and different issuers.
Don’t forget different geographies too. Rather than just investing in the Singapore market, consider investing internationally. Different markets tend to have their own economic cycles. What’s more, larger markets like the US will offer greater exposure to successful global companies the likes of Amazon and Apple.
2: Over-diversifying or under-diversifying
For investors who prefer to DIY stock pick, achieving a diversified portfolio may be a little more difficult. Many investors hold just a handful of stocks because building a portfolio with dozens of stocks is expensive after accounting for the brokerage charges for each purchase or sale. This exposes them to the risk of potentially losing a lot of money if one or several of their stocks tank.
So, is there a magic number of stocks an investor should own? There’s no single correct answer to this question, but research conducted with US investors suggests that the ideal number is about 20 to 30 stocks.
On the flip-side, over-diversification can become diworsification. Investing in 40 or even 50 different companies doesn’t mean you’re better diversified. Doing so in fact racks up your investment costs and ultimately eats into your investment returns. And unless you have time to continuously monitor your portfolio, you may start to lose track of your many investments and not notice that some of your companies’ fundamentals have changed.
As long as your stocks are spread across different sectors and there’s a healthy mix between large and small companies, sticking to 20 to 30 stocks is a good middle ground.
But if you don’t fancy the idea of having to manage a diverse portfolio of over 20 stocks, consider using Exchange Traded Funds (ETFs) as a way to gain instant diversification. ETFs allow you to invest in a basket of stocks with just one transaction. For example, if you buy the SDPR S&P 500 ETF, you are effectively investing in 500 top US companies.
3: Not checking your underlying holdings
Let’s say you’re invested in about eight different funds. That should give you ownership of hundreds of securities, which means you’re well-diversified, right?
Not so fast. If all your funds are invested in similar sectors or have similar investment mandates, there may be considerable overlap between their underlying securities. For example, you may find that your funds each own stocks of HSBC, JP Morgan Chase and Citibank, resulting in these three stocks forming about 20% of your portfolio. While we’re not saying that these aren’t good stocks, are you comfortable concentrating one-fifth of your portfolio in this particular sector? If the banking sector underperforms, this could have a disproportionately negative impact on your portfolio value.
Investors usually forget to pay attention to what their funds’ underlying holdings are as long as the fund names seem to suggest a sufficiently diversified portfolio. It’s worthwhile spending some time to look through your underlying securities to make sure you aren’t over-allocated to a specific company or group of companies through your funds.
How will you know if your portfolio is diversified?
A diversified portfolio is made up of assets that have no or low correlation. If you notice that your investment holdings are all going up or down by similar amounts at around the same time, your portfolio may not be truly diversified.
Ultimately, a well-diversified portfolio should have a meaningful allocation to multiple asset classes, sectors and geographies. Your ideal asset allocation is in turn determined by your risk profile, investment goals, and time horizon.
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