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What is diversification and how does it work

28 February 2018  |  EDUCATION

Diversification is a measure investors take to minimize the risk exposure on their investments. 

In this article you'll learn: 

How to minimize risk

How to diversify

How to classify stocks

What is a P/E ratio

Your profile as an investor

How to design and optimize your portfolio

Why do you need to diversify?

1. Reduce risk exposure. 

Let's suppose you buy stocks from a prominent oil company. The next day you read in the newspaper that their workers have gone on strike. The stock plummets. If you trade with a high percentage of your capital on this investment you suffer a big loss. But when you design a well-balanced and diversified portfolio with assets allocated in a wise manner, you don't have to be right 100% of the time. When you distribute your capital among various stocks, you reduce the risks inherent to financial markets. 

2. Maximise return by investing in different areas.  

Capital markets have a property called "correlation" and there are 3 kinds:  

•Positive Correlation: when the price of a stock rises, a stock with positive correlation goes up as well and vice-versa. 

•Negative Correlation: The price of a stock rises and the price of another which has negative correlation drops and vice-versa. 

•No Correlation: when both companies are independent of each other and their prices move without any correlation. 

Using the example of the oil company stocks... Imagine you buy shares from a multinational airline too and they have a deal to get aero gas from our oil company. The delays from a strike on the oil company affects the airline as well. Both markets have a positive correlation and the loss hits with double effect. But if you buy stocks from a social media company instead, an industry with no correlation, you're reducing your risk exposure. Having risk distributed among different industries is one the advantages of diversification.  

3. Think Long-Term. 

Stocks differ from each other for many reasons, one of them is their estimated value (capitalization).  

•Mega Caps: more than $200 billion. 

•Big Caps: more than $10 billion. 

•Mid Caps: between $2 and $10 billion. 

•Small Caps: between $300 million and $2 billion. 

•Micro Caps: between $50 and $300 million. 

•Nano Caps: less than $50 million. 

Are you wondering if nano caps are not worth your time and you should focus on big and mega caps? Think again. 10 years ago social media companies weren't even available to trade on stock exchanges. 

Today they are among la crème de la crème, also known as "blue-chip stocks". Of course, you shouldn't invest in equities only for their capitalization. Fundamental analysis is always due diligence. You need to assess the companies you're investing on and take a look at their dividends, earnings, and sales. Diversifying on stocks by capitalization gives your portfolio flexibility and variety. Be involved in the news that moves the markets. As you can see from all the examples above, the news has a direct impact on how public perceptions affect the value of shares.

Diversifying stock selection by capitalisation gives your portfolio flexibility and variety. Be involved in the news that moves the markets. As you can see from all the examples above, the news has a direct impact on how public perceptions affect the value of shares.

How to build your portfolio

1. Define your risk aversion.

Investors fall into 2 categories:  

Aggressive: usually younger people who are willing to take a riskier approach expecting to grow their investment. Their time horizon is longer.

Conservative: they have a more cautious mindset and focus their goals towards income. Usually older people.

This doesn't mean there can't be younger individuals who prefer to be more conservative in their investment decisions and vice-versa.

2. Choose your sectors (telecommunications, military, technology) and market caps.

The stock market offers a variety of sectors to invest in and includes many types of companies with different market caps. The market cap refers to the total dollar market value of a company’s outstanding shares and is used as a measure to determine a company’s size and strength.

Each stock market is unique and the dominant sectors in each market are often a reflection of the trends in the respective economy.  For example, The Australian economy is heavily reliant on the Mining and Financial Services sectors, and this is supported by the fact that these two sectors make up approximately 50% of the ASX 200. The United States tells a different story, with Information Technology as its largest sector and known global companies such as Apple, Facebook and Alphabet (Google) playing a part in this.

Whether it’s technology, financials, health care, etc. – it is important you understand the sector you wish to invest in when building your portfolio. Diversification benefits often occur when a portfolio is constructed with a variety of sectors and companies with a low or negative correlation.

3. Pick your stocks based on these categories:

•Growth stocks: projections show they tend to grow faster than the market. They entail more risk and at the same time more potential for reward.

•Income stocks: their price doesn't fluctuate as much and they tend to pay higher dividends over time.

•Value stocks: the market undervalues them but some of them might possess growth potential.

•Blue-chip stocks: companies that have been growing over a long period of time and the market perceives them as stable investments.

•Defensive stocks: companies which provide essential services like food or health.  

•Cyclical stocks: they go along with the economy and its cycles.

•Speculative stocks: usually young companies that offer innovative products and services, considered to be quite risky.

It’s important to notice that no stock is exempt to unpredictable moves caused by news releases or market volatility.

4. Perform fundamental analysis.

•How qualified and experienced is the management of the company?

•The industry cycles.

•How valuable is the company for its workers?

•P/E ratio.

P/E ratio (price-to-earnings ratio) is a useful indicator and it can tell you if the shares of a company are either overvalued or undervalued compared to its earnings.

P/E ratio=market value per share/earnings per share (EPS)

As an example let's use Airline X.Their shares are priced at $40 and their earnings per share are $3. Using the formula...

P/E ratio for Airline X=$40/$3.

13.3x. 

The P/E ratio is not expressed in AUD (or any other currency) because the "$" symbols in the numerator and denominator cancel each other on the equation.

It's expressed as a multiplier.

5. Determine reductions, reallocations and optimize your portfolio.

Once you've been investing for some time, you'll have to analyze and determine if a stock is adding to or hurting your portfolio.

When a stock doesn't perform as well as you expected it might be necessary to reduce or even close the position and re-allocate or keep in reserve your money for better-performing stocks and new investment opportunities.  

As time goes by you'll know yourself better as an investor and your risk aversion might change and it's necessary to keep track of this.

Conclusion

As you can see failing to diversify can lead to costly mistakes. Without a well-rounded and complete portfolio, you can be letting suitable opportunities pass by. A correct investment approach is vital to a healthy ROI.

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Risk Disclaimer: The information above is of general nature only and does not take into account your objectives, financial situation or investment needs. Prior to you make an investment decision, please make sure you carefully read and fully understand our Financial Services Guide, Terms and Conditions, Privacy Policy and other relevant documents that you can obtain from this website. Monex Securities Australia Pty Ltd (AFSL No. 363972; ABN 84 142 210 179) is the Financial services provider. Financial products trading carries risks and may not be suitable for all investors. You are strongly recommended to seek independent financial advice before making any investment decisions.

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