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Why and how to diversify your portfolio

Peter Garnry

Head of Equity Strategy

Summary:  Investors with only one or a few stocks in their portfolio are taking too much risk. This article looks at why and how diversification can maximize your potential for long-term gains by reducing risk.

The big risk: owning just a few stocks

Even the first steps of an investing journey should keep in mind that you are building a portfolio that will be with you for life. Sure, novice investors will often start their investment lives by testing the waters with the purchase of stock or two in companies they have some kind of connection to or feelings about. But this is rarely a setup for long-term success, and a diversified core portfolio is an important first principle of building more stable, long-term success.

When you only invest in a few companies, your entire portfolio depends on the performance of those companies. And while you can always see what happened in the rear-view mirror, no one can know how the future will shape up for a company. Imagine having built a portfolio consisting of Kodak, Blockbuster and Nokia stocks in the late 90’s after those three names stood atop years of spectacular gains. By the 2010’s all three companies had collapsed, leaving investors with virtually nothing. Worse still, investors having chosen individual shares often feel “married” to the position, hoping the prices will return to their highs and incapable of making the decision to exit the position, fearing the emotion that they will take a loss just at the wrong time, only to see the share prices soar again. That is the definition of “decision regret bias”

Diversification to the rescue

Diversification is the first tool investors should consider to avoid being caught with a risky portfolio where one event may jeopardize your savings and caught in the cross-fire of emotions that make decisions difficult. Diversification spreads your investments across sectors, countries and industries to lower your portfolio risk, while still maintaining exposure to the upward drift in the market over time. With a diversified portfolio a financial event may be negative for some of your investments but positive for others. Best of all, a broad exposure to the market triggers far fewer of the behavioural risks that choosing individual shares does. It’s quite a confidence boost to know that, with a more diverse approach the stock market has historically always come back over a long enough time horizon, even if individual companies may not.

The concept is shown in the graph above. As you can see, with a small number of stocks, the stock specific risk in your portfolio is high, but falls the more stocks you add and gets closer to the equity market risk, which is the risk you would have in owning shares in all listed companies in the world.

The power-up: Asset Allocation

s you can also see from the graph above, the effect of adding stocks decreases portfolio volatility risk the more stocks you add. If you want to diversify your portfolio further and thus lower the portfolio risk, you can add other asset classes like bonds to your portfolio, which historically usually don’t correlate closely with stocks for long periods – 2022 was a notable exception!

How to start diversifying your portfolio today

If you want to prioritise your savings well-being over emotional connection to investments, you’ll be happy to learn that it has never been easier to diversify your portfolio than today. That is because of two things:

  • Trading costs have fallen sharply (see Saxo’s new and very low commissions)
  • The deep exchange-traded-funds (ETF) market that offers a wide variety of powerful diversification options.

Diversifying your stock portfolio using single stocks

If you want to diversify your holdings you need a minimum of ten stocks across unrelated sectors. As inspiration, we have highlighted the two largest companies from each major sector in the US and Europe in the table below.

Diversify your stock portfolio using ETFs

If you want a thoroughly diversified portfolio, the best and most cost-effective way is through a global stock ETF. Simply put, basic ETFs are funds that hold a number of stocks but can be traded like a stock. The most popular ETFs track major stock indices. In Europe, the largest ETF providing exposure to global equities is:

Global equities: iShares Core MSCI World UCITS ETF

  • Saxo ticker: IWDA:xams
  • Contains: 1,500 stocks across 23 developed markets
  • Total assets: USD 72 billion
  • Dividends are not paid out but tax-efficiently reinvested into the fund
  • Annual costs are 0.2%

Add bonds to your portfolio to increase diversification

If you want to diversify your portfolio further, a relatively easy way to do so is by investing in a global bond ETF. In Europe, the largest ETFs providing exposure to global bonds is:

Global bonds: iShares Core Global Aggregate Bond UCITS ETF

  • Saxo ticker: AGGH:xams
  • Contains: around 14,300 bonds across key developed markets within government, corporate, and mortgage bonds
  • Total assets: USD 8.9bn
  • Dividends are not paid out but tax-efficiently reinvested into the fund
  • Annual costs are 0.1%

Below you can see a comparison of the performance (in USD) of the stock ETF, bond ETF and a portfolio with 50% in each. While the stock ETF has the best performance, there is less volatility in the 50/50 portfolio. Bonds have had a bad run due to a historic rise in interest rates, but if the next  five years would feature worse stock performance but fairly stable interest rates, the bond diversification would improve the outcome.

The point of diversification is that you should avoid taking company specific risks that you don’t have to take and get the most out of your savings while not having to worry.

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