With Volkswagen’s diesel cars apparently being more harmful for the environment than previously thought, the case for diversifying a portfolio just got that little bit stronger. Clearly, the allegations may be inaccurate or not tell the whole story – only time will tell. But, for investors, the damage has already been done to Volkswagen’s share price and, potentially, to its reputation.
In fact, Volkswagen’s share price has fallen by almost 30% in the last week and, as such, many of its investors will be sitting on large losses. Looking ahead, it seems likely that there will be multiple investigations into the emissions tests and, as a result, the issue could drag on over a period of months and act as a brake on the future share price performance of the company.
Of course, if an investor in Volkswagen had ploughed all of his/her money into the stock, then their portfolio would have fallen by almost 30%. However, if they had purchased a number of other stocks alongside Volkswagen, say nine others, then their total loss over the last week would have been just 3%.
This highlights the importance of diversification. It limits the company-specific risk which a portfolio faces and, should there be a profit warning, challenging industry outlook or, as in Volkswagen’s case, disappointing news flow, then it can allow the investor to maintain a degree of downside protection on his/her portfolio.
Clearly, buying more than ten stocks could be a good idea, since even a portfolio of ten companies is still relatively concentrated. Of equal importance, though, is to diversify among different industries within a portfolio, since they can offer different levels of performance at different times. For example, filling a portfolio full of mining stocks earlier this year would have led to severe losses, while buying only banks prior to the credit crunch would have crippled portfolio returns.
In addition, diversifying between different regions of the world is also of high importance. For example, in recent years many UK investors have focused on investing in companies with large exposure to China. And, while the world’s second-largest economy is still growing at a healthy 7%+ rate, uncertainty surrounding its longer term prospects has caused the valuations of China-focused stocks to come under severe pressure. As such, and while the Eurozone, for instance, may seem unappealing right now, it is sensible to mix up geographical location of stocks within a portfolio.
Similarly, buying solely high-yield or growth stocks can be problematic. That’s because rising interest rates may cause the valuations of high-yield stocks to come under pressure, while an economic downturn can put pressure on the growth prospects of highly rated stocks. Therefore, having a balance between the two within a portfolio can also make sense.
Of course, diversifying will not prevent losses entirely. However, it will allow your portfolio to absorb them more easily and prevent a complete wipeout which, realistically, can be very difficult for any investor to come back from.
