Picking stocks? Here’s why you should look at different sectors and countries
We reveal how investing in stocks from different sectors and geographies can help your investment portfolio.
Constructing a good stock portfolio requires time, patience and effort. This is because investing is about finding the balance between risk and return. Too much risk can result in big losses, especially in the short term. Too little risk, on the other hand, can hurt long-term returns.
One of the best ways for investors to balance between risk and reward is to consider diversifying their stock portfolio.
What is diversification?
In simple terms, diversification means spreading investments across several different assets that react differently to the same market or economic event.
"Diversification is often used when it comes to choosing what to invest in and managing risk," Leighton Roberts, sub-authorised representative of Sharesies AU Pty Limited, told Finder.
"Diversification basically means not putting all of your eggs in one basket. By investing across lots of different things, you spread your money around, which means you take less of a hit if one of those investments loses value."
Markets go up and down due to economic change, business cycles and various other factors that can affect investment returns. Smoothing these highs and lows is the primary goal of diversification.
"There are many different dimensions to diversification, and it's not just about how many things you invest in. It's also about what types of risks you are exposed to. Some ways investors diversify their portfolio include investing across a range of sectors, geographies, currencies and types of investments (asset classes)," Roberts says.
Different companies: The most basic way is to own shares in multiple companies so that the portfolio does not get significantly impacted if one stock declines or if any company goes bankrupt.
Different sizes: Another way is to invest in stocks of companies of different sizes, or market capitalisation. For example, small-cap, mid-cap and large-cap companies generally have distinct risk and return characteristics and tend to perform differently in the same market conditions.
Different sectors: Different sectors typically perform at different paces, so holding stocks across a number of sectors ensures that the portfolio contains counterweights.
For example, technology companies are considered high growth but risky. On the other hand, infrastructure or pharmaceutical companies generate very stable earnings and are therefore useful to counter volatility.
Different countries: Similar to sectors, different countries experience different economic factors such as gross domestic product (GDP), interest rates and political events. Owning stocks in different countries/markets allows investors to benefit from whichever region is enjoying growth at any given time.
"A question you can ask yourself is how each of your investments will respond to the same event," Roberts says.
"Take for example when a crisis hits, different industries will be impacted differently and potentially at different times. Some may fall, and others may rise."
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Main reasons it pays to diversify your stock portfolio.
1. Reduces risk
Overall risk in a portfolio is a combination of either systematic risk or unsystematic risk.
Systematic risk refers to the overall market risk that affects all stocks and cannot be avoided through diversification. For example, the stock market crash during the global financial crisis also affected stocks of companies that had little to do with the housing or financial markets.
Unsystematic risk is generally specific to a company or sector and can be mitigated through diversification. For example, a portfolio broadly focused on the travel sector may have dropped significantly after the market suffered during the coronavirus pandemic. But if the travel sector accounts for only a part of a portfolio that also has stocks from other sectors like banks, pharmaceuticals, technology, etc., there is a far lower risk of a significant decline.
Proper diversification can't prevent systematic risk, but it can limit the unsystematic risk from an investor's portfolio.
2. Preserves capital
The long-term goal of investing includes not making losses, i.e. preserving capital and generating profits on this. Diversification helps achieve this by limiting investors' exposure to loss on an individual stock.
Many investors, especially those who are closer to retirement, are more keen towards the preservation of their savings and a diversified portfolio can aid this.
It is more stable because not all investments will move in sync, making it less susceptible to volatility in the market.
For example, depending on their risk profile and investment goals, investors can invest a portion of their portfolio in stable dividend-generating stocks such as banks or real estate investment trusts (REIT) thereby shielding themselves from sharp market movements.
3. Boosts returns
Diversified portfolios generally provide more consistent returns over the long term, compared to concentrated portfolios.
Markets often experience periods of rotation where certain sectors attract capital at the expense of another, resulting in one sector outperforming others. A well diversified portfolio will expose an investor to sectors, stocks and economies that will outperform in future years. So, diversification ensures that an investor portfolio always has some exposure to leadership sectors and markets.
Given the globalisation in recent decades, an increasingly popular method to boost investment returns has been to move away from a domestic-only portfolio and lifting exposure to stocks in foreign markets.
This is often achieved by taking exposure to riskier but higher return generating emerging markets.
Take the example of an investor who has equally divided their portfolio between foreign and domestic holdings. The international portfolio (focused on emerging markets) rises 20%. Even if the domestic portfolio were to decline by 10%, it would still leave the investor with an overall return of 10%.
Some investment platforms allow access to stocks in multiple countries, increasing opportunities for investors to diversify their holdings across different geographies. For example, the investment app Sharesies allows members to invest in New Zealand, Australian and US stocks all on the same platform.
Some important points one needs to keep in mind while investing in overseas markets are:
Currency exposure: When investors buy stocks in foreign markets, they also gain exposure to the currencies in which those stocks are quoted. While this often helps neutralise the fluctuations in the investor's home currency, it can also enhance the risk of loss during times of market volatility.
Market cycles: Investors in foreign markets can take advantage of the favourable market cycles of different countries resulting from factors such as capital inflows or demand for commodities. Conversely, losses in foreign markets can often dampen stable returns secured in the domestic share market.
The last few years have seen a type of alternative diversification: investing in local small businesses. This is mainly influenced by the logic that local brick and mortar businesses are quite resilient during periods of recession.
Generally, economic downturns see a decline in overall spending as people feel insecure about personal finances. However, consumers often turn to affordable treats and luxuries during such periods of stress, for example bars and restaurants.
While larger firms may be impacted by global issues and supply chain disruptions, small businesses are able to weather the storm through proper resourcing and funding. Investing in local businesses also supports the local economy.
It is important to note that all investing is risky, especially in periods of economic downturn.
Picking an investment platform
To buy investment products in Australia, you will need to sign up to an online broker or full-service broker. The right broker for you will depend on how you prefer to invest and what you're investing in.
If you're planning to invest a large sum of money it always pays to get advice from a financial advisor.
If you're looking to buy stocks, you can do so yourself through an online share trading platform such as Sharesies.
Image: Getty Images
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