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2016 Proves Why You Need To Diversify

Since the turn of the year, a number of stocks in the FTSE 100 have recorded major falls. Any investor who had placed 100% of his/her capital into any one of those stocks would have recorded major losses and their financial outlook would be a lot worse as a result.

Therefore, it’s clear that buying more than just one stock is crucial. However, this logic can also be applied to an entire sector too. For example, the resources sector has endured an extremely painful period where billions has been wiped off the valuations of iron ore miners, oil and gas plays, as well as other commodity plays. Therefore, buying shares in more than one industry sector makes sense.

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Geographic mix

2016 has also shown how one geographic region can disappoint on a major scale. Even though the world is becoming more globalised, economic growth rates remain very different in different parts of the world. Investors solely focused on China, for example, would be hurting after a number of weeks of declining investor sentiment towards the region that has pushed China-focused stocks to new lows. Therefore, buying stocks with a tilt towards the US, Europe and also towards developing markets seems to be a sound strategy.

In addition, the volatility witnessed thus far in 2016 has proved that owning purely cyclical stocks can be a poor move. Certainly, they offer excellent long-term growth potential and are worth holding in many cases, but with a number of defensive stocks barely falling in value during the course of the year, they can be a useful ally during turbulent economic conditions. Looking ahead, more volatility seems likely so defensive stocks alongside cyclicals could be a wise investment.

Weighing up the risks

Although investors have generally been risk-averse since the turn of the year, there’s still a place for smaller, higher risk stocks within a portfolio. As well as offering high long-term growth potential, smaller companies can benefit from having a lower correlation with their larger peers. And with them often operating in niche markets, smaller companies sometimes offer better protection from global economic trends than their larger peers.

Clearly, low interest rates are back on the agenda after a period of great economic uncertainty. While a couple of months ago discussion among investors was centred around how many interest rate rises there would be in 2016, today it seems likely there will be none. As such, owning a mix of high-yield stocks seems to be a sound move. Likewise, economic conditions could improve, so having purely income plays may prove to be a short-sighted move too.

While many investors fear diversification because it can dilute returns if stock selection ability is strong, it also reduces company-specific risk. As such, the risk/reward ratio tends to improve with more diversification and with the FTSE 100 having fallen this year, there are a number of companies that offer bright long-term futures. With many of them being very different to one another, buying a range of them now for the long term could prove to be a prudent step to take.

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Peter Stephens has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Apple. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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