Does researching 15 or more companies across 8 or more sectors, each offering a different blend of yield, potential growth and risk seem daunting?
Remember there are a range of businesses offering assistance, including stockbrokers, investment newsletters, financial advisors, and accountants.
There are also alternatives. In coming articles, we will discuss some shortcuts to a diversified share portfolio: including ‘share packs’, Exchange Traded Funds, and Listed Investment Companies.
One of the most powerful ways to reduce share investment risk is to diversify (as mentioned our introduction to share investing). The questions are: how, and how much?
Diversify company risk
Numerous studies show that risk drops dramatically in a portfolio of 10 to 15 companies, and that the bulk of the risk reduction benefits have been achieved by the time a portfolio holds 20 to 30 companies. Unsurprisingly therefore most privately managed portfolios hold around 15 to 20.
More recent studies show that to eliminate all diversifiable risk (relative to a market index) requires 100 companies or more, but if this is your goal, we would recommend investing in an index fund. (We will discuss these in coming articles.)
Simply buying a dozen or more different companies is not enough, through. Few investors would consider a portfolio of 15 mining stocks diversified, for example. Diversification also requires that you spread your risk among different types of company, that is, into different sectors.
Diversify sector risk
So what sectors should you consider and in what proportions? Most share investors either formally or informally compare their results with ‘the market’ and this makes sense as it is the past investment performance of ‘the market’ that attracted them in the first place.
As such a good starting place for considering what sectors to buy into is the sector breakdown of ‘the market’, starting with the larger, more stable companies in the 200 biggest companies listed on the Australian Stock Exchange, the ASX 200.
These sector sizes are convenient as a portfolio where each holding is 5% to 7% of the total portfolio will hold 15 to 20 companies. To roughly match the sector diversification, therefore an investor could buy one company each in Industrials (manufacturers), Health Care, Consumer Staples (think food and beverage), Telecommunications, Consumer Discretionary (cars, clothes, white-goods, leisure etc) and Energy, then buy two Materials companies (construction materials), and seven Financials.
Other things to think about when choosing companies to invest into
- Large, well established ‘blue chip’ companies suit a lower risk appetite and a more limited time horizon.
- Smaller companies involve more risk (including the risk of total capital loss) but offer the possibility of higher returns over longer periods of time.
- High yield companies have a track record of paying high, fully (or nearly fully) franked dividends, so your return does not rely so much on the price going up. These are very attractive to those close to, or already in retirement.
- High growth companies often pay low dividends as they are investing the bulk of their profits within the business – offering the possibility of greater price appreciation over time.
As always, we suggest you seek personal financial advice before embarking on direct share investment.
What are your thoughts?
Do you own shares? Is there more you’d like to know about share investing? Join the conversation — leave a comment below and let us know what you’re thoughts are.
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