Research undertaken by Goldman Sachs Asset Management shows that around one third of Australian retail investors are planning to invest more funds in local shares in 2014, with little mind for diversification as they seek another year of double-digit gains.
Given the low interest-rate environment, Australian investors are already heavily exposed to equities as an investment class. This proved to be a successful strategy in 2013 with the S&P/ASX 200 (Index: ^AXJO) (ASX: XJO) climbing over 15%, driven by some of Australia's largest blue chip stocks such as the big four banks or Telstra Corporation Ltd (ASX: TLS). This was due in part to their generous dividend distributions.
While such strong gains are recognised, it's easy to get caught up in the lure of the stock market. However, the volatile start to 2014 (which has seen the market fall by over 3%) has highlighted the necessity of maintaining a diversified portfolio whereby the weaknesses and risks associated with some stocks are offset by the strengths and gains of others.
Here are some ways investors can look to diversify their portfolio:
- Maintain a cash holding: Although the lure of the stock market is strong, investors should always have access to cash. Firstly, you never know when you're going to need it – for instance, your car may breakdown and you need to get it repaired, or work may become hard to come by. Secondly, while the stock market will rise in the long-run, there is no way of knowing where it will go in the short-term. In case of a downturn, you don't want to have all your wealth exposed to the market. What's more, if such a downturn were to occur, having access to cash could allow you to buy shares at heavily discounted prices!
- Exposure to different industries: Stocks in a single industry will often behave in a similar fashion to other stocks in that industry. While the release of good news could see both companies increase in value, bad news could see both stocks fall heavily. To spread the level of risk being assumed, it is wise to invest across different sectors that will less likely move in tandem with one another. For example, you could invest in M2 Telecommunications Group Limited (ASX: MTU) to gain exposure to Australia's booming telecommunications industry, while also taking a risk on BHP Billiton Limited (ASX: BHP) in the mining sector.
- Diversify by size: Growth companies can deliver far more impressive gains than Australia's blue chips, but are more volatile to market movements. Investors should aim to give their portfolio a solid foundation made up of well-established companies such as Woolworths Limited (ASX: WOW) or Telstra, whilst also exposing it to growth companies such as Cochlear Limited (ASX: COH), with slightly higher risk.
- Look beyond Australia: The Australian stock market represents just 2% of the global stock market and is heavily concentrated in the finance and mining sectors. This means that weakness in either sector is likely to drag the entire ASX down with it. By venturing into foreign stocks, investors can not only spread their risk, but also expose themselves to some of the strongest companies in the world, such as Google Inc (NASDAQ: GOOG) or Amazon.com, Inc. (NASDAQ: AMZN).
