The power of portfolio diversification

Highlights in this issue:

*** Diversify and conquer...
*** The sage of Omaha bucks the trend yet again...
*** 20 shares will minimise risk... and more...

From Gary Booysen on the top floor...

Dear Investment Academy Reader,

So the day has finally arrived. I set out three weeks ago to tell you a little about diversification and building a successfully diversified equity portfolio, but we got a bit sidetracked. To recap, first we went through the importance of knowing what assets you have available to invest, the level of investment you should choose and your purpose for investing in the first place. We then looked at the different asset classes available to you. Today, we’re going to focus on exactly what diversification is, when you should use it and how to apply this technique to build wealth. If you missed the last couple of editions of the Investment Academy. check out our archive at www.fsp.co.za.

What is diversification?

Diversification is, essentially, not putting all your eggs in one basket. The idea is, if you select shares that all fall under one sector and something negative happens in that sector, your portfolio will be blown to bits. In Fear, Greed and the Stock Market, Gareth Stokes (editor of MoneyWeek) looks at an example of two separate investors. One invests in Telkom and MTN, the other chooses five shares across four different sectors. The result is that, if there’s a negative shock in the telecoms market, undiversified investor A loses all his money, whereas “wiser” investor B manages to ride out the storm as he’s diversified. Diversification basically takes some of the risk out of the wilder fluctuations in the stock market.

How do I diversify?

The secret to a well diversified portfolio is to select shares with a low correlation coefficient. This means when the price of one share goes up, the price of the other share should come down. To do this, it’s important you’re aware of two different types of company: The cyclic company and the defensive company.

The cyclic company: These companies respond quickly to changes in the business cycle. The share price of this company will rise faster than the average share in a bull market – called “overshooting”. Cyclic sectors include retailers, transport, general industry and property. (Remember, as fast as these shares rise, they can also fall.)

The defensive company: This company is more stable through business cycle fluctuations. When a bear is roaring, these share prices fall slower than average share prices. The sectors that maintain traction in falling markets are food retailers, pharmaceuticals and insurance. These are sectors providing essential services and profits are unlikely to fall, even with terrible market conditions.

How many shares make a portfolio diverse?

According to Investopedia, the common consensus is that a well-balanced portfolio, with approximately 20 shares, “diversifies” away the maximum amount of market risk. Diversification irons out the wrinkles in the stock market. But while this might stop big losers dragging down your overall portfolio, it’ll also negate the impact of big winners to some extent. 

Warren Buffett, the greatest value investor of all time said: “Wide diversification is only required when investors do not understand what they are doing.”

This can clearly be seen in our monkey portfolio, which is doing swimmingly despite containing only three shares.

Next week, look out for some portfolio adjustments.

Until then – keep learning!

Gary Booysen
for the Investment Academy