South Africa has a comparatively small equities market, with only a handful of significant shares across a few sectors available to invest in. Unfortunately, it puts investors at risk of having a highly concentrated portfolio.
It’s crucial to find ways to lessen concentration risk and diversify your portfolio.
The Johannesburg Stock Exchange (JSE), when compared to global markets, is small; it comprises less than 1% of the total of the investing world. Furthermore, it’s exceedingly concentrated. The top 10 shares on the FTSE/JSE All Share Index (ALSI) make up between 50% and 60% of the index.
In comparison, the top 10 shares in one of the world’s foremost indices, the S&P 500, make up just over 20% of the index.
In some examples a single share can make up as much as 20% of an investors’ portfolio, making them more susceptible to concentration risk if their dominant share underperforms. It begs the question, ‘what happens when the dominant share(s) in your portfolio begins to perform poorly?
How you can lessen your concentration risk
Portfolio diversification is suggested to be the best way to reduce concentration risk and have the potential to earn good returns. By investing in a combination of assets that have little to no association with each other, you have a wider spread of assets from which to generate returns, balancing out the level of risk of possible fluctuation, for example, changes in unit trust prices if you are investing in unit trusts.
Considering correlation and volatility
To construct a diversified portfolio, correlation and volatility need to be considered. Correlation measures the strength of the relationship between the returns of two assets.
A positive correlation means that the two assets are inclined to have higher and lower returns simultaneously – this means a portfolio is undiversified.
Conversely, a negative correlation means that the assets’ returns move in opposing directions. A correlation of zero means there is no relationship between the assets. A portfolio containing assets with negative and/or zero correlation means that a portfolio is diversified.
Volatility allows you to measure how well your portfolio is diversified. A portfolio comprising of correlated assets should be highly volatile, and one consisting of negatively correlated assets should have low levels of volatility.
So, it’s fair to deduce that if you have a well-diversified portfolio, your investment should generate returns at lower volatility levels over the long term.
It’s best to diversify your portfolio
Does this sound overwhelming? It’s worthwhile considering investing in a balanced fund. They are available locally and internationally and may be less susceptible to market fluctuations than other less diversified funds.
How it works: Your investment manager chooses several uncorrelated assets from different industries, markets, and companies which can generate good returns, lessening the potential of concentration risk.
To diversify your portfolio further, consider investing in more than one of the same types of fund through different fund investment managers. Should you choose this option, it’s essential that the assets are not the same because this has the potential to increase your portfolio’s concentration risk due to the weighting of duplicate shares.
If this is overwhelming, speak to an independent financial adviser (IFA). He/she can help you assess the concentration risk in your portfolio and offer you the appropriate advice.
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