Why and how to diversify your investment holdings including by asset allocation, industries, countries, and by time.
Diversification helps reduce risk by allocating investments in different investments, industries, markets, and other categories. Diversification helps reduce the risk of a single investment failure wiping you out, and gives you improved results in different market and economic conditions. At the same time, you will want to avoid making each investment holding too small that it is meaningless or having too many investments that you cannot monitor all your investments. A good investment allocation guideline would be between 10 to 20 different investments. We look at four harmonious way to diversify your investments below.
The fundamental diversification for all portfolios would be between higher risk and lower risk investments. A good starting point would be an age-based allocation with higher weight in higher risk investments when younger, and increasing lower risk weight as one ages. When one is a young investor, you have a longer time horizon to sit through possible long-term market downturns. When one is an older investor nearing retirement, you will want to avoid the potential of your portfolio dropping by 20-50% when you will most need the funds.
- Do not be overly cautious, especially when young. While it is possible to slowly work towards financial independence, investing wisely in higher risk investments helps you reach your goal faster.
- Even when one is getting on older in years, you should still have some % in higher risk investments in today’s low yield environment.
Different sectors perform differently during different parts of the economic cycles. You can categorize sectors by industry (e.g. finance, technology, consumer products, property, construction, industrial) or by company shares profile (e.g. dividend stocks, small fast growing companies, cyclical stocks, turnaround companies). Having a reasonably diverse sector mix will help make sure some investments perform while others may decline, and reduce portfolio volatility. A good sectors mix would be to have 5 to at most 10 different sectors.
- Do make sure that your diversification is really across different sectors. Having many investments but all in the same sector is not diversification.
- Pick the best (or at most top 2) companies within each sector while constructing your investment portfolio.
Diversification across different markets in different countries help increase exposure in different market segments, reduce country risks, and gain access to large global companies listed in foreign markets. It is impossible to predict which market will outperform (or under perform) in any given year, which strengthens the case for diversifying across different markets. Mature markets (i.e. US) and emerging markets (i.e. Malaysia) also have different characteristics notably with emerging markets generally seen as more volatile, higher political instability, and higher potential growth.
- Find out the long-term historical performance of the market you are considering investing in and your familiarity with the country (and her companies). For most investors, you will be familiar with your own country’s market (i.e. Bursa Malaysia), and a well-known developed market (i.e. US markets) will give a good base of foreign stocks exposure.
- Be aware of forex risks as currency fluctuations can significantly affect your returns (in either direction), and the effects of taxation.
Many of us have heard of dollar cost averaging (DCA) which has similarities to time diversification. Do avoid investing all your available capital at a single time (or worse in a single investment at a single time). A rule of thirds is a good base to never buy (or sell) more than a third of your investment at any one time.
“Never buy the high, never sell the low” ~Honma Munehisa
Modern studies have disproved the theory that constant (i.e. monthly) DCA increases your overall returns. If you know what you are doing, investing in bigger chunks produces superior returns most of the time. For long-term value investors, these means making investments in chunks regularly (as long as it is within your buy range). This helps you avoid over paying, reduces the risk of market sell-offs, and you benefit from having more funds invested more of the time.
- Review your investment portfolio at least once every 6 months to see if the companies you have invested in have changed fundamentally, or whether are you overweight in any areas.
- Consider working with a Personal Finances Advisor who can help you to structure and improve your investment allocation planning, thus increasing your returns and reducing your risks.
Caution Against Over-diversification
Do not diversify just for the sake of reaching an arbitrary diversification number or goal. It is still more important to invest in companies that you are fully familiar, and confident in. You should make every investment a sizable and meaningful amount. You can build diversification one investment at a time with a long-term goal in mind.
“Diversification is protection against ignorance. It makes little sense if you know what you are doing.” ~Warren Buffett
(If you are not sufficiently confident to bet on which asset/class will do well and which will do poorly.)
How to Implement Diversification
For most folks, you will want to start diversifying in this flow:-
- Diversify by Asset Allocation (low-risk and high-risk investments).
- Diversify by Sector (different industries and market segments).
- Diversify by Markets (familiarize with a country/market first, before moving to the next).
Note: Diversifying by Time is dependent on your cash flow, and availability of identified investment opportunities.
Share and Discuss
What have you learned about diversification that will help your investing journey?
What other diversification tips or advise would you like to share?