Diversity is the key to avoiding unnecessary risk with your investments, but what exactly does diversity mean in relation to investments, and how can you achieve it without having a large sum of money to invest?
Portfolio diversity simply means having a variety of investments; whether that be a variety of investment types, such as shares, property and bonds – or shares from a variety of different companies.
Shares have two risk components, diversifiable risk and undiversifiable risk. Diversifiable risk is a risk that is related to a particular business or industry, for example, the government announcing an increase to the first-homebuyer’s grant would boost shares in the building and real estate industries, but may not have a great deal of impact on other markets. An undiversifiable risk is one that will impact the economy as a whole – a rise or fall in interest rates for example. Because of its system-wide impact, an undiversifiable risk will affect all shares, so it won’t matter which shares you own.
In order to have a fully diversified portfolio, you should aim to have shares with as little similarity (correlation) as possible. For example, owning shares in Qantas and Virgin would result in a higher level of correlation than owning shares in Qantas and Coles, while Coles and Woolworths would also have high correlation. A high level of correlation suggests that the companies being compared are likely to be impacted by similar events.
Consider a situation where the price of aviation fuel rises dramatically. Both Qantas and Virgin are likely to be significantly affected, with a resulting drop in share price. If your portfolio includes both these shares, it will drop accordingly. On the other hand, Coles is likely to be less affected by the price spike in aviation fuel, so that portion of your portfolio will remain consistent while Qantas shares fall. Further, if you happened to own shares in a shipping, road or rail company that is likely to benefit if air transport is more expensive, then the drop in Qantas prices may be completely offset by a gain in your other transport shares.
As you can see, the exact process for evaluating the level of correlation between shares is more complex than it first appears, and requires a good understanding of the market to manage successfully. Additionally, because each share trade incurs a cost, small investors will find it expensive to buy small parcels of shares in a large number of different companies (statistically, a portfolio may need shares in up to thirty different companies to be fully diversified). So what are the options for investors – particularly smaller investors?
A managed fund pools the contributions of its members (in the same way that your superannuation fund does) and has finance professionals choosing how to invest that money. Unlike listed investment companies and exchange traded funds, managed funds are not listed on the stock exchange, so you do not profit from buying and selling shares. Instead, a portion of the fund’s profit is normally paid out to members in regular distributions. As the name suggests, managed funds are actively managed in an effort to provide better than average returns.
Listed Investment Companies
Like a managed fund, a listed investment company (LIC) uses its funds to purchase a diverse range of investments; however LICs are listed on the stock exchange and the capital for investing is raised from an initial public offering (IPO) of shares. Investors in an LIC purchase shares in the LIC rather than in individual companies it owns shares in, so it provides smaller investors the opportunity of owning a portion of a diversified portfolio for low cost. The return for investors is usually in the form of franked dividends, where the LIC pays out a portion of its equity, having first paid the 30% company tax rate on the dividend (this has the added benefit of providing a tax credit for the recipient of the dividend).
Exchange Traded Funds
Exchange traded funds (ETF) also provide investors with the opportunity to purchase shares in the fund, rather than in individual shares. While LICs are actively managed (where finance professionals research the market attempting to provide better than average returns), ETFs are passively managed (the fund purchases shares across a particular market index, such as the ASX 200, with the aim of receiving the average return for that particular market).
While each option has its pros and cons, the key aspect of all three is that they allow smaller investors to benefit from a diversified portfolio that reduces both the risk and the cost of investing in the share market. As such, they provide an ideal entry point for many first-time investors.