Talk of Australia’s Housing Bubble Being About to Pop

All investments intrinsically carry with them a risk of loss. Experienced investors have learned hard lessons on how to mitigate these risks and prevent profuse losses. One of the ways to reduce risk exposure on one’s investments is diversification.

In Australia, the current rulers of the stock market are the mining and finance sectors. These, for a long time have been seen as the most stable and most rewarding stocks to invest in within the country. This, however, is about to change as our market shifts and gears itself for a new era where tech companies shape the economy. If you had opted to go all in on the housing sector, now is the time to change tact before this house of cards begins to crumble.

Diversification involves investing in different markets and sectors that have little or no effects on each other. This prevents one from experiencing double (or even triple) losses if one market crashes. For example, if you buy stocks in an oil company as well as an automotive company, a crash in the oil market could result in drop in the automotive stocks since the sectors are tightly linked and thus you lose twice. If, instead, you invested in an IT company, a crash in the oil sector will not result in a proportional loss on the rest of your portfolio. The IT stocks may even serve to cushion you against the shock loss experience by your oil stocks.

Correlation

This brings us to the topic of correlation, which is often overlooked by rookie investors. There are three types of correlations when talking about capital markets:

Positive correlation – Where a change in one stock results in a directly proportional change in another.
Negative correlation – Where a change in a stock results in an opposite change in another.
No correlation – Where a change in a stock in no way affects the value of another stock.

While many would go for positively correlated stock with the mindset that any gains in one stock will result in a proportional gain in another stock, the often forget that the same apply to losses. Professional traders realise this and thus peg their portfolio on stocks that have negative or no correlation so as to reduce the impact of unpredicted losses.

Investing in different sectors is thus a good way to diversify your portfolio. For example, instead of putting all your eggs in the housing basket, you could look to invest in health and telecommunication stocks as well, so as to mitigate the risk of losses when the housing bubble pops.

Another way to diversify your portfolio involves buying into a totally different market. With the dawn of offshore trading, you can invest your capital in markets such as the American and Chinese markets which may not be affected by fluctuations in your local market. Foreign markets may also have different dominant sectors or industries allowing for even further diversification. For example, the American market is topped by blue chip companies such as Apple and Google, which can be contrasted by the AUX 200 which is dominated by mining and finance companies.

Stock types and market cycles

Stocks can go up, down or sideways. Doing your due diligence on the stage of certain stocks and economies can help maintain a balanced portfolio that is less impacted by market cycles and smooth out your returns. Different stock types that can diversify your portfolio include:

Growth stocks – These are more fluctuant but do offer a larger potential of growth over a short period.
Income stocks – These tend to be more stable and also pay out higher dividends.
Blue chip stocks – These are the mature companies that dominate the market and are viewed as a source of stable income
Defensive stocks – Include companies that provide essential services such as health.
Speculative stocks – These are new companies that offer innovative goods and services and have a large potential for growth.

Having a portfolio that lists all these stock types, which may be going through different market cycles, can greatly cushion you against the risk losses that comes with every investment move you make.

At the end of the day, diversification does more than just mitigate risks. It also exposes you to great market opportunities and capture investment opportunities in different market cycles. As time goes, you should always ensure you analyse your portfolio and optimise it, either by taking away stocks and investments that are lagging, or buying more of what looks promising. Also investing in various asset classes can greatly diversify your portfolio.

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