With more than 2,000 companies listed on the Australian Securities Exchange there’s no shortage of choice when buying shares. However, it’s vital to consider not only the credentials of each individual company, but also how they relate to others that you’re investing in.
Diversifying a share portfolio
You can never know which sector will perform best in any given time period. By investing in varied sectors you can often help spread your risk as the performance of different sectors will generally be impacted by different factors.
Whether the sectors that companies sit within are considered ‘cyclical’ or ‘defensive’, is one thing to consider.
Cyclical sectors, such as property and retail, tend to move with the wider economy, while defensive sectors, such as telecoms and healthcare, often perform better than others when the broader economy is struggling, as the state of the economy has less influence on the demand for the goods and services they produce.
It’s good to think about what would happen in a range of scenarios – a change of government, a slowdown in economic growth, a natural disaster, a global oil shortage – and consider how your investments would be affected.
Investing beyond Australia
While there is plenty of variation in terms of the performance of companies listed on the ASX, they are all affected in some way by the Australian economy.
That's why investing in international shares may be one way to add further diversification to your share portfolio.
Investors in Australia can get exposure to overseas companies in a number of ways, including investing directly using an international trading account with a broker such as CommSec, or by buying units in a managed fund or exchange traded fund.
There are however, additional risks that come with international investing, such as currency risk that it's important to consider.
Diversifying at a portfolio level
Beyond diversifying a share portfolio, there is diversifying at a portfolio level, using different types of investments, such as cash, property and fixed interest. A large part of getting the right mix in a portfolio is using different investment types to help protect against market volatility and reduce risk.
Diversifying a portfolio aims to balance any losses in one investment against gains in others, although decisions as to the composition of a portfolio should be informed by individual circumstances and personal risk appetite.
Diversifying at a portfolio level works in theory as different types of investments have different levels of risk and also tend to respond differently to external triggers and events - such as a cash rate change, for instance.
The benefits of diversifying
By holding a diversified portfolio, you won't equal the top return for any given year, but nor should you equal the lowest.
The more ways you diversify, the more likely you are to reduce your risk.
There are four broad asset classes of equities (stocks and shares), property, cash and fixed interest, and these can be separated into two broad groups: defensive and growth investments.
Cash and fixed interest are typically viewed as defensive investments which aim to provide steady income with stable returns. Defensive investments are seen as carrying less risk of volatility, but do not usually grow significantly in capital value over time. Returns are generally lower than growth investments over the medium to long term.
Property and shares are growth investments which can provide income, as well as an increase in capital value over the medium to long term, but not without an additional element of risk that it's important to weigh up in the context of personal goals and circumstances.