The diversification dilemma

There are many principles of investing that are considered compulsory, and one of these is the need for diversification.

This means having a mix of investments in your portfolio, rather than just a few, in the hope of reducing risk without dramatically compromising the returns you’re likely to get.

It can mean spreading your capital over different asset classes, such as bonds and fixed income as well as shares and real estate, or ensuring you own a range of companies across multiple sectors.

It protects you from the risk of major losses, should something go wrong with one of your individual investments or companies.

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The last few years have given us plenty of examples of why we should diversify.

In the twelve years to the end of 2020, essentially the post-GFC period up until the emergence of COVID-19, the New Zealand sharemarket had a stellar run.

It outpaced world shares (in New Zealand dollar terms) in nine of those 12 years, falling only once (by just 1.0 per cent in 2011) and returning an impressive 14.0 per cent per annum (including dividends).

World shares still did fine, delivering 10.0 per cent annually over that period (also including dividends), but the local market was the place to be.

However, the tables have turned since then.

The domestic NZX 50 index is down slightly this year, on track for a third successive annual decline having fallen 14.9 per cent since the end of 2020.

In contrast, world shares are up 21.0 per cent so far in 2023 and have rallied 33.7 per cent in that near three-year period.

The local market will have its time in the sun again, but unless investors are good enough to know when to chop and change, they’re better off having a bit of both.

There are similar examples at an industry level.

Technology was the place to be when the pandemic first hit, with the US tech sector rising 42.2 per cent in 2020.

Nobody wanted a bar of the energy sector that year, and it was the worst performer with a 37.3 per cent decline.

That soon turned around, with energy stocks (which typically do well during periods of high inflation) surging 47.7 per cent in 2021 before rallying another 59.0 per cent in 2022.

A well-diversified portfolio would include more than just two industry sectors. There are many great businesses to be found in the healthcare, consumer staples and industrials space, but you get the idea.

While diversification is important, there is a limit to how far and wide investors should spread their capital.

At some point, expanding your holdings further won’t reduce portfolio risk much more and you’ll simply end up with more securities than you’ve got time to monitor.

There’s no magic number or right answer, but as a general rule a sufficiently diversified share portfolio is one that holds 20 to 30 investments across a range of sectors and regions.

If you choose to focus on individual companies alone, you might need a few more than that, but if you’re combining stocks with funds you can get away with less.

A good adviser will help you with getting this balance right, and it’s something that can be tailored specifically for you, depending on how much capital you’re working with and what you’re trying to achieve.

Even though diversification is a widely accepted portfolio building block, some of the world’s greatest investors don’t practice it themselves.

Warren Buffett famously said that “diversification is a protection against ignorance” which “makes very little sense for those who know what they’re doing.”

A fair point, but not everyone is Warren Buffett.

For every investor that’s done well out of a few big bets, there’ll be another who put too much faith in the wrong idea and got burnt.

That said, there’s nothing wrong with a more concentrated approach, provided you understand the additional risk you’re taking.

It’ll give you the potential for bigger gains if you’re good enough to back a couple of big winners, but the chances of failure are higher too.

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