How to achieve adequate diversification in investing

THE saying – diversification is the only free lunch in investing – holds a lot of truth.

Coined by the renowned economist Harry Markowitz, it emphasises how you can manage risk effectively without sacrificing potential returns. At its core, investing is about putting your money to work to generate solid long-term returns while avoiding unnecessary risk.

Risk refers to the chance of losing your capital permanently. But how do you diversify your portfolio effectively? While the advantages of diversification are clear, are there any potential downsides to this strategy?

Diversify your industry exposure

Thanks to the rise of online brokerages like Moomoo and Tiger Brokers, building an investment portfolio has never been easier. With a few clicks or taps, you can own shares in companies across a variety of sectors.

But here’s a question: Is your portfolio truly diversified in terms of sector exposure? For example, you might think you’re diversifying by purchasing shares of all three major banks in Singapore – DBS Group, UOB and OCBC.

While you’re spreading your investments across different banks, you’re still heavily concentrated in the banking sector, which is known to be cyclical, meaning it’s sensitive to economic shifts.

To achieve better diversification, consider adding companies from various industries. For instance, you could invest in real estate investment trusts (Reits) like Frasers Centrepoint Trust or Mapletree Industrial Trust. Tech stocks, such as Apple or Meta Platforms, also offer exposure to a rapidly growing sector.

You might also look at discretionary retail with companies like The Hour Glass, telecommunications with Singtel, or healthcare through Haw Par Corporation. With access to markets, not only in Singapore but also in Hong Kong, Europe and the US, you can easily create a well-rounded portfolio across diverse industries such as cybersecurity, airports, Chinese tech, education and more.

The key is to avoid over-concentration in sectors that are closely tied to the same economic cycles. For example, luxury goods and banks tend to move in tandem during economic downturns, in that both suffer when the economy dips.

To balance this, think about adding sectors that are more recession-resilient, like education or healthcare, as a hedge against downturns. A truly diversified portfolio mixes sectors that respond differently to economic changes and interest-rate fluctuations, thus helping to reduce risk when unexpected events arise.

Broaden your geographical coverage

In addition to sector diversification, it’s crucial to ensure your stocks are geographically diversified as well. Geographic diversification isn’t about where a company is listed; it’s about the countries or regions where its revenue comes from. By spreading your investments across different regions, you reduce your exposure to the risks of a downturn or recession in any one country.

A recent example highlights this point. Hedge funds that made big bets on China faced massive losses last year. Some were even forced to close as the country’s stock markets struggled due to a prolonged economic slump. To avoid similar risks, consider investing in companies with global operations, where no single country makes up the bulk of their revenue.

Take Kimberly-Clark as an example. The consumer-goods giant, known for Huggies nappies and Scott napkins, sells its products in over 175 countries, ensuring it’s not overly reliant on any single market.

Benefits of diversification

Now that you have a better understanding of how to diversify your portfolio, let’s explore some of the key benefits of this strategy. By spreading your investments across a wide range of positions, your portfolio is protected if any one company faces trouble.

For example, imagine a portfolio with 30 positions, each making up about 3.3 per cent of the total value. Even if two companies go bankrupt, only 6.6 per cent of your portfolio would be affected.

The beauty of a long-term investment strategy is that companies can continue to grow and increase their share prices as long as they consistently boost their revenue and profits. So, if just two companies in your portfolio see their value multiply fivefold, their gains would easily outweigh any losses from those that fail.

This simple scenario also highlights the importance of position sizing. In reality, most investors don’t hold equal positions in all their stocks. The goal is to allocate more capital to stocks that carry lower risks and align with your highest convictions, while reducing or cutting back on those facing ongoing problems.

This approach to diversification allows you to capture significant upside potential while keeping your downside limited.

Another important benefit of diversification is the ability to tap into emerging industries. Take generative artificial intelligence and electric vehicles, for instance. Both show strong long-term potential.

By dedicating a small portion of your portfolio to companies in these sectors, you can benefit from their growth and be part of the exciting developments shaping the future.

Beware of “diworsification”

While diversification helps reduce risk, it’s not without its drawbacks. Peter Lynch, the legendary hedge fund manager who delivered an average annual return of 29.2 per cent for the Magellan Fund from 1977 to 1990, coined the term “diworsification” in his book One Up on Wall Street.

Diworsification happens when companies expand into areas that are so different from their core competence areas that their overall business suffers.

The same could happen to your portfolio. You “diworsify” by including businesses that you should avoid. One common way is by investing in companies from declining industries with shrinking revenues. If these businesses are losing money, hoping for a quick turnaround is unrealistic.

Another example is to buy heavily indebted companies in cyclical industries such as construction. The risks of such investments often outweigh the potential rewards, making them poor choices for diversification.

Over-diversification = mediocre returns

Diversification can be taken too far. A well-balanced portfolio typically includes 20 to 30 stocks, spread across various industries and regions. However, some investors go to the extreme, packing their portfolios with 100 or more stocks.

There are two key downsides to doing this. First, it’s nearly impossible to effectively track and manage over 100 companies. Second, and more importantly, over-diversification can lead to mediocre returns.

Even if some stocks perform exceptionally well, their gains may not make much of an impact on the overall portfolio’s value.

Diversify smartly

Smart investors diversify effectively, ensuring their portfolio includes a solid mix of stocks across different industries. It’s also important to regularly review your portfolio and assess whether each company deserves to stay in it.

By diversifying wisely, you can enjoy strong, long-term returns while also taking advantage of the growth potential in emerging sectors like artificial intelligence.

The writer owns shares of DBS Group, Apple, Meta Platforms and Mapletree Industrial Trust. He is portfolio manager of The Smart Investor, a website that aims to help people invest smartly by providing investor education, stock commentary and market coverage