Constructing an investment portfolio is not as easy as it looks.
And this task just got much more difficult during this pandemic.
COVID-19 initially started as a health crisis, but its impact has led to many countries to suffer sharp economic losses.
More than ever, it has highlighted the importance of being diversified.
While there are proponents for and against diversification, I argue that almost all retail investors need some level of diversification within their investment portfolios.
Let’s take a look at some compelling reasons for doing so.
It’s for the birds!
In author Mark Tier’s popular book “The Winning Investment Habits of Warren Buffett and George Soros”, he says that master investors believe that “diversification is for the birds”.
In a nutshell, the argument is that experienced investors need not adhere to the normal rules for diversification.
With their expert knowledge and savvy, they can concentrate their firepower on just a few winning positions.
This approach allows them to grow their wealth at astounding rates, as both Buffett and Soros have achieved.
You should, however, look at this argument in its proper context.
Hardly anyone can even compare themselves to the investment savvy of the two legendary gurus.
As a retail investor, you should make an honest appraisal on whether you can achieve the same level of knowledge and expertise as Buffett and Soros.
There is no shame to admit if you can’t do so. Few investors, if any, can measure up to the investing greats.
Focusing on just a few stock positions may seem smart.
But should anything go wrong with these positions, most of us also do not have the deep pockets to endure severe losses.
Peter Lynch’s “Diworsification”
Fund manager Peter Lynch, who delivered an annual return of 29% between 1977 and 1990, coined the term “diworsification” in his seminal book “One Up on Wall Street”.
The term refers to companies that buy businesses that are unrelated to its core operations.
The same concept applies to our investment portfolios.
In essence, you should not diversify just for the sake of it, as the addition of weak companies into your investment portfolio only serves to erode returns contributed by the better companies.
So, what exactly constitutes “wise” diversification that leads to better results?
Diversifying into companies or industries that you understand well, and being disciplined to avoid those that are outside your circle of competence.
Buffering against crises
You may be surprised to learn that not all businesses have suffered during this pandemic.
This crisis has shown itself to be unusual in that some businesses have thrived because of it, while others have been dealt a disastrous blow.
In fact, economists are now using the term “K-shaped recovery” to describe the bifurcated fortunes of various economies.
While the downturn has decimated the tourism and travel industries, those offering essential services have managed to stay resilient. Some have even done better due to the pandemic.
Diversification ensures that your portfolio does not only contain companies that are adversely impacted by the crisis but also contains businesses that can survive and emerge stronger.
Examples of businesses that are suffering include Singapore Airlines Limited (SGX: C6L), Singapore Press Holdings Limited (SGX: T39) and Haw Par Corporation Ltd (SGX: H02).
The pandemic has decimated air travel, reduced spending on advertisements and disrupted the supply chains for the distribution of healthcare products.
On the other side, the crop of businesses that have done well includes glove manufacturer Riverstone Holdings Ltd (SGX: AP4), grocery retailer Sheng Siong Holdings Ltd (SGX: OV8) and test and handling solutions specialist AEM Holdings Ltd (SGX: AWX).
By owning a wide range of businesses, you increase the chances of including a resilient or thriving company within your portfolio that offsets the adverse impact of those that are not performing well.
Capturing opportunities
Diversification is not just about reducing your risks, but it is also a way to capture opportunities.
The pandemic has accelerated the shift towards digitalisation, leading to a boom to a whole host of businesses in the space.
Companies with a strong online presence have also remained relatively unscathed.
Social media company Facebook (NASDAQ: FB) has continued to chalk up higher revenue and profits, all the while enjoying a boost in daily and monthly average users.
Rural lifestyle retailer Tractor Supply Company (NASDAQ: TSCO) just reported record third-quarter results with sales up 31.4% year on year. Net profit soared 56.1% year on year as more people focused on farming and gardening during the pandemic.
Meanwhile, Nike (NYSE: NKE), the sporting footwear and apparel giant, has leveraged on its digital presence to increase its digital sales by 82% year on year for its fiscal 2021 first quarter. Net income for the quarter rose 11% year on year.
And let’s not forget cloud-based companies such as Salesforce.com (NYSE: CRM). The customer relationship management software-as-a-service (SaaS) provider enjoyed a record-breaking quarter with its second-quarter revenue up 29% year on year.
A balance between growth and dividends
Finally, diversification allows you to balance your investment objectives by giving you opportunities to invest in companies that fulfil different criteria.
Having spoken to a wide variety of investors over the years, I realised that most of them want to enjoy a combination of steady growth and passive income from their investments.
This combination of growth and dividends can be attained by owning stocks that offer different value propositions.
You can choose to buy newly-listed, loss-making companies such as Snowflake (NYSE: SNOW) and Asana (NYSE: ASAN) to capture the latest hot trend for cloud companies.
By sizing these positions smaller, you limit the amount you may lose and thus reduce overall portfolio risk accordingly.
These more speculative positions can be balanced by steady and consistent dividend payers such as Singapore Exchange Limited (SGX: S68) or REITs such as Mapletree Industrial Trust (SGX: N2IU).
The point here is to partake in the rewards that both categories of businesses provide through diversification, all the while controlling the risks through prudent position sizing.
Discipline and patience for the long-term
Being diversified is just one part of the equation, though.
At The Smart Investor, we believe in investing for the long-term and letting our winners compound.
Diversification will allow you to own a wide range of businesses, not all of which are going to perform well.
Business conditions, randomness and occasional bad luck may result in some investments turning sour.
However, the long-term winners should more than make up for the duds and allow you to significantly grow your wealth over years.
All it takes is discipline and patience to stay the course and not falter.
Not even when a pandemic hits our shores.
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Disclaimer: Royston Yang owns shares in Singapore Exchange Limited, Facebook and Nike.