The meaning of ‘diversification’ when it comes to ASX shares

Diversification… Here we have one of those sharemarket ‘buzzwords’ that is probably thrown around a bit more than it should be. Every fund manager on the market will tell you about the importance of diversification, and perhaps how every one of their investment portfolios is ‘diversified’.

But then you have legendary investors like Warren Buffett, who has said that “diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing”.

So what’s the deal on the D?

Diversification and its benefits

So the whole idea of diversification comes from risk management. The concept revolves around the simple proposition that if one of your investments gets hit by the proverbial bus, it won’t have a ruinous impact on your wealth. It’s the old ‘don’t have all of your eggs in one basket’ strategy.

This does make sense. And it is important to try and plan for any scenario that might come to pass, no matter how inconceivable it might seem at the time. I’m sure no one thought there was too much external risk owning seemingly-good quality businesses like now-delisted Virgin Australia, Qantas Airways Ltd (ASX: QAN), Webjet Limited (ASX: WEB) or Corporate Travel Management Ltd (ASX: CTD) at the start of the year.

Yet, if you had a substantial portion of your wealth in one or more of these companies back then, your portfolio would have looked very dire in March and April. Virgin has since gone bankrupt, wiping its shareholders out. It was no fault of these businesses’ or their management of course. But that doesn’t really matter when it comes to the value of one’s portfolio.

Thus, you can see how it is important to not have ‘all of your eggs’ in one sector or industry.

Geography matters too

But does ‘good diversification’ stretch beyond just one sector of one share market? Well, let’s take a look at that famous disparager of diversification: Mr Buffett. Warren Buffett has always been a patriot who routinely tells investors to “never bet against America”.

Yet, Buffett has spent 2020 ‘diversifying’ Berkshire Hathaway Inc‘s (NYSE: BRK.A)(NYSE: BRK.B) from American companies, selling US shares like his bank positions, Costco Wholesale Corporation (NASDAQ: COST) and Apple Inc (NASDAQ: AAPL), and buying massive stakes in large Japanese industrial conglomerates like Mitsubishi.

Every country has its own set of intrinsic risks, such as currency stability. Thus, spreading out your investments (diversifying) across multiple countries can mitigate risk as well. Especially if you might be worried about your own country’s unprecedented quantitative easing (QE) programs, as Buffett might be. If you don’t fancy buying Japanese industrials like Buffett, an internationally-focused exchange-traded fund (ETF) might be a good alternative to consider.

Foolish takeaway

You might not be able to afford the same apathy towards diversification that Buffett boasts of (you’re not alone there). Thus, it pays to remember that none of us can know what is just around the corner. Diversification is one easy way you can acknowledge this in your portfolio of investments, so use it wisely!

More reading

• These were the worst performing ASX 200 shares last week
• Are ASX stocks about to get an earnings upgrade boost in the new year?
• Why BetMakers, Medical Development International, Qantas, & Zip are dropping lower
• REX Airlines (ASX:REX) share price rockets up 13%, smashing 52-week high
• Qantas (ASX:QAN) share price in focus after market update

Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. owns shares of and recommends Apple, Berkshire Hathaway (B shares), and Costco Wholesale and recommends the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares), short January 2021 $200 puts on Berkshire Hathaway (B shares), and short December 2020 $210 calls on Berkshire Hathaway (B shares). The Motley Fool Australia owns shares of and has recommended Corporate Travel Management Limited and Webjet Ltd. The Motley Fool Australia has recommended Apple and Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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