Diversifying Your Stock Portfolio

If you have ever heard of the proverb, "don't put all your eggs in one basket", you will probably understand the concept of diversification. In the context of your investments, not only does this piece of advice make sense, it could well be the difference between your financial success and failure, as a single unexpected event can throw your financial plans off track had you invested your monies entirely in a single stock or geographical market. A diversified stock portfolio, on the other hand, will help to limit volatility and protect against huge losses in market downturns.

Here's Why Diversification Matters

When it comes to stock investing, diversification involves spreading your capital across several stocks spanning different sectors and geographical markets, to help protect your portfolio from the effects of any one market trend, event or setback. The goal of diversification is not to enhance investment performance, but rather, to manage and reduce overall portfolio volatility, especially in the face of stomach-churning market swings. While it does not guarantee against losses, well-diversified investors often survive a downturn in the markets better than those who are not diversified. Consider this real-world example: if you had sunk all your savings into the shares of DBS Bank at its peak in July 2015, your losses would have amounted to about -22.1% by the end of the year. For investors with a long term investment horizon, there is still time for them to recoup their losses as markets recover, but for investors who are nearing retirement age or may have urgent liquidity needs, the impact of a decline on this scale can be catastrophic. In comparison, if you had held half of your portfolio in the shares of DBS Bank and the other half into the more defensive Thai Beverage, your total losses would have been a smaller -16.2%. While still not ideal, diversification has certainly helped to cushion some losses in this scenario.

Asset Allocation Strategies

There is more to the market than just stocks, and a well-diversified portfolio will usually include different types of asset classes. At the most basic level, investors should have at least a mix of bonds and stocks, selected from various geographical markets, in their portfolios, and how much of each will depend on the individual investor's investment horizon, risk tolerance and financial goals. Conservative investors will want to incorporate a significant weighting in fixed income, while investors with a greater appetite for risk may want to adopt a larger weighting in stocks. Within these baskets of assets, investors must also determine their geographical exposure to various regions, taking into consideration factors such as economic growth, interest rates and political stability. Investors may choose to have a greater exposure to regional markets that they believe will do well, while remaining cautious on the ones that do not offer any investment value. Upon determination of the asset allocation strategy, investors will need to do periodical rebalancing as the asset mix originally created by an investor inevitably changes as a result of differing returns among various securities and asset classes.

Diversify Your Stock Holdings

The stocks portion of your portfolio should also be well-diversified across various geographical regions, sectors and market capitalisations. Investing in different companies within the same industry does not provide you with adequate diversification, as an industry-wide downturn can negatively impact the stock performance of all companies within that industry. Similarly, you are also exposed to concentration risks even if you spread out your capital across companies in different industries, but all within the same geographical market, as economic uncertainty or political turbulence in a single country can affect the performance of all stocks in that particular market. Another important consideration is the risk profile of the stocks – do you prefer the large-cap blue chips with stable businesses, or do you want exposure to the fast-growing (but riskier) small to mid-cap stocks? Investors should also limit their stock portfolios to only a handful of holdings. While there is no hard and fast rule to determine the optimal number of stocks that a well-diversified portfolio should have, having a portfolio of 10 – 20 stocks is usually a good starting point. Not only does a bloated stock portfolio ratchet up your transaction costs, monitoring the fundamentals of each stock can become a challenging task with a big portfolio.

Diversifying Through A Fund

It is important to diversify our portfolio because there is no way for us to know when or which asset classes or geographical markets will be the best performing or worst performing markets for sure. The key is to determine your investment mix and the respective weightings in terms of asset classes and geographical markets. For young investors who have just started out in their careers and may not have enough savings on hand, diversification of their portfolios can be a daunting task. As such, investing in a multi-asset fund or an exchange-traded fund will be a cost-efficient way for them to achieve diversification should investment monies be a constraint.