How to achieve adequate diversification in investing?
The saying diversification is the only free lunch in investing-holds a lot of truth. Coined by the renowned econo mist Harry Markowitz, it emphasises how you can manage risk effec- tively without sacrificing potential returns. At its core, investing is about putting your money to work to gen erate solid long-term returns while avoiding unnecessary risk.
Risk refers to the chance of losing your capital permanently. But how do you diversify your portfo- lio effectively? While the advantages of diversification are clear, are there any potential downsides to this strategy?
Building an investment portfolio has never been easier. With a few clicks or taps, you can own shares in companies across a variety of sectors. But here’s a question: Is your portfolio truly diversified in terms of sector exposure? For example, you might think you’re diversify. ing by purchasing shares of all three major banks in Singapore – DBS Group, UOB and OCBC. While you’re spreading your in vestments across different banks, you’re still heavily concentrated in the banking sector, which is known to be cyclical, meaning it’s sensitive to economic shifts.
To achieve better diversifica tion, consider adding companies from various industries. For in- stance, you could invest in real es- tate investment trusts (Reits) like Frasers Centrepoint Trust or Ma- pletree Industrial Trust. Tech stocks, like Apple or Meta Plat- forms, also offer exposure to a rap- idly growing sector. You might also look at discre- tionary retail with companies like The Hour Glass, telecommunications with Singtel, or healthcare through Haw Par Corporation. With access to markets, not only in Singapore but also in Hong Kong. Eu- rope and the US, you can easily create a well-rounded portfolio across diverse industries such as cyberse curity, airports, Chinese tech, edu- cation and more.
The key is to avoid over-concen- tration in sectors that are closely tied to the same economic cycles. For example, luxury goods and banks tend to move in tandem dur- ing economic downturns, in that both suffer when the economy dips. To balance this, think about adding sectors that are more reces- sion-resilient, like education or healthcare, as a hedge against downturns.
A truly diversified portfolio mixes sectors that respond differ ently to economic changes and in terest-rate fluctuations, thus help- ing to reduce risk when unexpected events arise. Broaden your geographical coverage. In addition to sector diversifica- tion, it’s crucial to ensure your stocks are geographically diversified as well. Geographic diversifi- cation isn’t about where a company is listed; it’s about the countries or regions where its revenue comes from. By spreading your investments across different regions, you reduce your exposure.
To diversify effectively, investors should avoid over-concentration in sectors that are closely tied to the same economic cycles.
risks of a downturn or recession in any one country. A recent example highlights this point. Hedge funds that made big bets on China faced massive losses last year. Some were even forced to close as the country’s stock markets struggled due to a prolonged economic slump. To avoid similar risks, consider investing in compa- nies with global operations, where no single country makes up the bulk of their revenue.
Take Kimberly-Clark as an example. The consumer goods giant, known for Huggies nappies and Scott napkins, sells its products in over 175 countries, ensuring it’s not overly reliant on any single market. Now that you have a better understanding of how to diversify your portfolio, let’s explore some of the key benefits of this strategy. By spreading your investments across a wide range of positions, your portfolio is protected if any one company faces trouble.
For example, imagine a portfolio with 30 positions, each making up about 3.3 per cent of the total value. Even if two companies go bankrupt, only 6.6 per cent of your portfolio would be affected.
The beauty of a long-term in vestment strategy is that compa- nies can continue to grow and increase their share prices as long as they consistently boost their reve nue and profits. So, if just two com panies in your portfolio see their value multiply fivefold, their gains would easily outweigh any losses from those that fail.
This simple scenario also highlights the importance of position sizing. In reality, most investors don’t hold equal positions in all their stocks. The goal is to allocate more capital to stocks that carry lower risks and align with your highest convictions while reduc ing or cutting back on those facing ongoing problems.
This approach to diversification enables you to capture significant upside potential while keeping your downside limited. Another important benefit of di- versification is the ability to tap in to emerging industries. Take generative artificial intelligence and electric vehicles, for instance. Both show strong long-term potential. By dedicating a small portion of your portfolio to companies in these sectors, you can benefit from their growth and be part of the ex- citing developments shaping the future.
While diversification helps reduce risk, it’s not without its drawbacks. Peter Lynch, the legendary hedge fund manager who deli vered an average annual return of 29.2 per cent for the Magellan Fund from 1977 to 1990, coined the term “diworsification” in his book One Up on Wall Street. Diworsification happens when companies expand into areas that are so different from their core competence areas that their overall business suffers.
The same could happen to your portfolio. You “divorsify by in cluding businesses that you should avoid. One common way is by investing in companies from de-clining industries with shrinking revenues. If these businesses are losing money, hoping for a quick turnaround is unrealistic. Another example is to buy heav ily indebted companies in cyclical industries such as construction. The risks of such investments of ten outweigh the potential re- wards, making them poor choices for diversification.
Over-diversification mediocre returns Diversification can be taken too far. A well-balanced portfolio typically includes 20 to 30 stocks, spread across various industries and re- gions. However, some investors go to the extreme, packing their port- folios with 100 or more stocks. There are two key downsides to doing this. First, it’s nearly impos sible to effectively track and man- age over 100 companies. Second, and more importantly, over-diver- sification can lead to mediocre re- turns. Even if some stocks perform exceptionally well, their gains may not make much of an impact on the overall portfolio’s value.
Smart investors diversify effec- tively, ensuring their portfolio in- cludes a solid mix of stocks across different industries. It’s also im- portant to regularly review your portfolio and assess whether each company deserves to stay in it. By diversifying wisely, you can enjoy strong, long-term returns while also taking advantage of the growth potential in emerging sec- tors like artificial intelligence. The writer owns shares of DBS Group, Apple, Meta Platforms, and Mapletree industrial Trust. He is portfolio manager of The Smart Investor, a website that aims to help people invest smartly by providing investor education, stock commentary and market coverage
Best is a shift among industries and geographies ( India, US, China, Emergency markets ) when building your portfolio, and review it regularly.
