Learning about shares: Shares to spread the risk, increase the fun

Olympic champ BARBARA KENDALL gets help from NZX's Dan Dividend

Q. Barbara asks: We briefly covered diversification in our discussion of risk last week. Can you tell me how many shares I need to have in an adequately diversified portfolio?

A. Dan Dividend responds: Good question. I'll start with a re-cap on diversification before I call on this week's guest NZX broker.

As we discussed last week, you can use diversification to reduce the risk of your investments.

In share investing, diversification means buying a range of shares across different industries. Share prices move independently - some might be up, others might be down. However, by spreading your investments, overall your money should be growing at a nice steady pace.

Including companies with different risk levels in your portfolio is another diversification tool. You could buy into a big, well established company that dominates its industry, and a young company that looks set to take on the world.

The start-up company would tend to have more risk associated with it than the established company.

You can also diversify into overseas companies, as global markets rarely follow the same trends. You can buy shares in almost any market around the world through your NZX broker.

I'll now hand over to our guest broker, Kirsty Shiach from Macquarie Equities in Auckland.

Kirsty says: Diversification reduces risk because conditions that cause a fall in the share price of one company might not affect another.

For example, the removal of tariffs might cause a manufacturer and exporter of goods to scale down operations and lay off staff, but will not affect a tourism operator.

Another bonus is that diversification gives you more exposure to shares that might be performing really well. If your portfolio includes a variety of carefully selected companies, chances are that at any time, some of them will always be doing better than the average.

How many shares does it take to be diversified? There are many different opinions on this topic, but 12 shares is my guideline.

With that number of carefully selected shares, you should have a portfolio that is diversified enough to protect you from a great deal of the risk involved with individual shares.

However, it's a bit of a catch-22 for beginner investors, as many people do not have enough spare money to buy into 12 different companies at once.

If this sounds like you, I suggest starting with a couple of well-established companies from different sectors - perhaps two companies from the NZSX 10 index.

You could then buy into one or two smaller, emerging companies that you think have excellent growth potential.

How many is too many? It is possible to get carried away with diversification and end up being over-diversified.

If you own too many shares, a dramatic rise in one company's share price can be dampened down.

Imagine a large team enters a relay race. The team includes Mary, the regional sprinting champion, and Mike, who is recovering from injury and can only jog very slowly.

Mary clocks the fastest time of the day for her part of the race, but Mike's time is very slow. The other team members, all fairly good runners, finish with times in between the two.

The team as a whole, although boosted by Mary's time, finishes in the middle of the field.

Likewise, a stellar performer in your portfolio can be averaged out of significance if your team of companies is too big.

A large number of shares can also become difficult to manage and could cause you to lose focus on your original investment goals.

With a fully diversified portfolio your overall return might be lower than the return you could get from two or three shares. However, it will also have less dramatic ups and downs and will bring more certain returns.

NEXT: Dan Dividend and a guest broker consider asset allocation in investment portfolios.

GOT A QUESTION?: Feel free to email Dan Dividend with your questions