Facebook Inc (NASDAQ: FB) shares suffered their largest drop in the company’s history last week. An estimated $119 billion was wiped out in the company’s value in one day.
That was the big news last week when the social media giant reported disappointing results. But a few weeks before that Facebook was one of the market’s darling stocks. It is part of what is called the FANGs– Facebook, Apple Inc (NASDAQ: AAPL), Netflix Inc (NASDAQ: NFLX) and Google (owned by Alphabet Inc). It is a formidable group of companies that have led the US stock markets higher over the past several years.
But now retail investors, as well as big fund managers who have long positions on tech stocks, must be rethinking their holdings.
The fall in Facebook’s share price (and that of other companies as well) is not unusual in a market that goes through cycles. And it’s in cases like this when investors need to have a diversification strategy that can protect their overall portfolio.
No doubt you must have heard the saying about not putting all of your eggs in one basket.
For investors, this is one of the most important things to keep in mind. It is crucial to your investment growth and protection. You need to diversify your investments, in my opinion.
You may be asking yourself why should I diversify if I know what I want in terms of investment and I know what I’m comfortable with?
Let’s have a look at some of the key reasons why you need to diversify your portfolio.
Remember that markets move up, down and sideways. Each market cycle presents different investment opportunities. Many investors were caught out when mining stocks went out of favour. The same thing happened during the dot.com bubble. If all of your investments are in assets that are falling in price, you will have to endure the pain of a market sell-off (and potential losses) before values rise again.
Diversifying into assets that are at different stages of the cycle will help to smooth out your returns, helping you to avoid the deepest drawdowns.
Many investors place their hard-earned funds into the assets they are most familiar with. For many people, this means property and a handful of big-name companies listed on the local stock exchange. But these investors are missing out on moves that may be taking place in commodities or interest rate markets or even in industries that are not well represented on the local stock exchange.
With diversification, you can have a portion of your portfolio invested in a broad range of asset classes so that you have the opportunity to participate in a broader range of market moves.
All successful investors count on a risk management strategy that ensures capital protection and preservation. As another market saying goes: ‘You need to preserve your capital to be able to invest for another day.’ Diversification – allocating a certain percentage of your investment capital in different assets – is an effective way to protect your capital, or at least a percentage of it, when some of your investments suffer from falling prices.
Now we know the key reasons why we need to diversify, let’s consider three different ways to introduce diversification in an investment portfolio.
While most investors know the need to diversify their portfolio, some are not confident in how to do it. Some who lack the time and resources to review their investments on a regular basis may end up holding the same stocks for longer than necessary.
Australia ranks high among the developed countries in terms of stock ownership.
According to the 2017 ASX survey of share ownership in Australia, 37 per cent of the country’s adult population – an estimated 6.9 million people – invest in a securities exchange. 31% hold shares, 7% hold derivatives and another 11% hold other on-exchange investment assets.
There are also a significant number of Australians that invest in property. According to a recent CoreLogic property investment report, there are approximately 2.03 million individual property investors in the country.
By combining different asset classes in your portfolio, you can be ensured of the benefits of diversification as you go through the different market cycles.
It may be hard to believe but it is true that some investors get emotionally attached to certain stocks. There are also investors who hold only one or two stocks, which could be risky if the majority of their capital is tied to these limited investments.
If you invest in different industries and sectors, you have a better chance of capturing investment opportunities in several areas. It also gives you a certain level of protection when one sector enters a downward trend while the others are trending higher.
The thing to remember here is that different industries move in different directions. Some are more positively or negatively correlated than others.
As an investor, you want to be invested in sectors that are not all closely correlated to one another, so a portion of your investment can still be protected while others are going through a rough patch.
Australian investors are also known to have one of the highest levels of home country bias – the tendency to buy and hold shares from their domestic market. As I’ve pointed out before, this ‘ Home Country Bias‘ is one of the biggest factors that can limit your investment potential.
If you are only investing in the Australian stock market, which represents less than 3% of the world’s total market capitalisation, you are missing out on massive investment opportunities around the world.
While Australia is a mature investment market and home to some of the world’s largest companies – e.g. BHP Billiton Ltd (ASX: BHP) and Rio Tinto Limited(ASX: RIO) – the undeniable fact is there are numerous investment opportunities around the globe.
You need not look far to see that some of the household names – Apple (maker of iPhones), Amazon(where you buy books and almost everything online) and Facebook (your social media channel) are listed on exchanges outside of Australia.
By investing in these technology and social media companies, you are giving your portfolio a much-needed boost.
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