Why Diversify?
Diversification helps to reduce risk by allocating your capital into different investments, industries, markets, and other categories. Diversification helps reduce the risk of a single investment failure wiping you out, and gives you better results in different markets and economic conditions.
You should avoid making each investment holding too small or else the small profits you get in return becomes meaningless. On the other hand, too many investments make it difficult for you to monitor it all. A good investment allocation guideline would be between 10 to 20 different investments (assuming you have a big capital).
We look at four basic ways to diversify your investments below:
Asset Allocation
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. For example, you should put more money in higher risk investments when younger, and increase the amount you put into lower risk investment as you age.
If you are a young investor, you have a longer time horizon to sit through possible long-term market downturns. If you are 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.
Tips:
- 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 older, you should still have some % in higher risk investments in today’s low yield environment.
Sectors (Industries)
Different sectors perform differently during different periods 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, which reduce portfolio volatility. A good sector mix would be to have 5 to 10 different sectors.
Tips:
- Make sure that your diversification is across different sectors. Having all your investments in the same sector is not diversification.
- Pick the best (or at most 2) companies within each sector while constructing your investment portfolio.
Markets (Countries)
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. Emerging markets are generally seen as more volatile, with higher political instability, and higher potential growth.
Tips:
- Find out the long-term historical performance of the market you are considering to invest in and your familiarity with the country (and its companies). You are most likely familiar with your own country’s market (i.e. Bursa Malaysia). DIversifying into this 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)
- Take note on the effects of taxation.
Time
Many of us have heard of “dollar cost averaging” which is similar to time diversification. Avoid investing all your available capital at a single time (or worse, in a single investment at a single time). One practical advice is to never buy (or sell) more than a third of your investment at any one time.
Some 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 range). This helps you avoid overpaying, reduces the risk of market sell-offs, and you benefit from having more funds invested more of the time.
Tips:
- Review your investment portfolio at least once every 6 months to see if the companies you have invested in have changed fundamentally, or whether you have too much capital in any areas.
- Consider working with a professional who can help you to structure and improve your investment allocation planning, thus increasing your returns and reducing your risks.
- Diversifying by time is dependent on your cash flow, and availability of investment opportunities.
Caution Against Over-diversification
Do not diversify just for the sake of diversification. It is still more important to invest in companies that you are familiar with. 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.
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).
