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The forgotten risk of not diversifying
Peter Garnry
Chief Investment Strategist
Investors with only one or a few stocks in their portfolio are taking too much risk. This article looks at why and how diversification can maximize your potential for long-term gains by reducing risk.
The big risk: owning just a few stocks
New investors will often start their investment lives by testing the waters with the purchase of stock or two in companies they have some kind of connection to or feelings about. But this is rarely a setup for long-term success, and a diversified core portfolio is an important first principle of building more stable, long-term success.
When you only invest in a few companies, your entire portfolio depends on the performance of those companies. And while you can always see what happened in the rear-view mirror, no one can know how the future will shape up for a company. Imagine having built a portfolio consisting of Kodak, Blockbuster and Nokia stocks in the late 90’s after those three names stood atop years of spectacular gains. By the 2010’s all three companies had collapsed, leaving investors with virtually nothing. Worse still, investors having chosen individual shares often feel “married” to the position, hoping the prices will return to their highs and incapable of making the decision to exit the position, fearing the emotion that they will take a loss just at the wrong time, only to see the share prices soar again. That is the definition of “decision regret bias”
Diversification to the rescue
Diversification is the first tool investors should consider to avoid being caught with a risky portfolio where one event may jeopardize your savings and caught in the cross-fire of emotions that make decisions difficult. The idea with diversification is that you spread your investments across sectors, countries and industries to lower your portfolio risk, while still maintaining exposure to the upward drift in the market over time. With a diversified portfolio a financial event may be negative for some of your investments but positive for others.
Best of all, a broad exposure to the market triggers far fewer of the behavioural risks that choosing individual shares does. It’s quite a confidence boost to know that, with a more diverse approach the stock market has historically always come back over a long enough time horizon, even if individual companies may not.
The concept is shown in the graph above. As you can see, with a small number of stocks, the stock specific risk in your portfolio is high, but falls the more stocks you add and gets closer to the equity market risk, which is the risk you would have in owning shares in all listed companies in the world.
How to start diversifying your portfolio today
If you want to prioritise your savings' well-being over emotional connection to investments, you’ll be happy to learn that it has never been easier to diversify your portfolio than today. That is because of two things:
- Trading costs have fallen sharply (see Saxo’s new and very low commissions)
- The deep exchange-traded-funds (ETF) market that offers a wide variety of powerful diversification options.
Diversifying your stock portfolio using single stocks
If you want to diversify your holdings you need a minimum of ten stocks across unrelated sectors. As inspiration, we have highlighted the two largest companies from each major sector in the US and Europe in the table below.
Diversify your stock portfolio using ETFs
If you want a thoroughly diversified portfolio, the best and most cost-effective way is through a global stock ETF. Simply put, basic ETFs are funds that hold a number of stocks but can be traded like a stock. The most popular ETFs track major stock indices. In Europe, the largest ETF in terms of total assets providing exposure to global equities is the iShares Core MSCI World UCITS ETF.
Add bonds to your portfolio to increase diversification
If you want to diversify your portfolio further, a relatively easy way to do so is by investing in a global bond ETF. In Europe, the largest ETF in terms of total assets providing exposure to global bonds is the iShares Core Global Aggregate Bond UCITS ETF.
Below you can see a comparison of the performance (in USD) of the stock ETF, bond ETF and a portfolio with 50% in each. While the stock ETF has the best performance, there is less volatility in the 50/50 portfolio. Bonds have had a bad run due to a historic rise in interest rates, but if the next five years would feature worse stock performance but fairly stable interest rates, the bond diversification would improve the outcome.
Please note that this isn't a recommendation of those two specific ETFs as you need to be ensure that any specific investments suits your risk profile, time horizon and investment objectives.
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