Why you might have more investment risk than you need to have
Why do a third of the people that own shares hold less than 3 securities?
I wish I knew the answer.
According to the ASX, only 38% of Australians own Australian shares (only 32% own shares directly). The average number of holdings for those people is only 2.19 securities.
Maybe it’s because there are a number of people who have never really chosen to be in shares in the first place – they got their shares through a demutualisation (like when NRMA gave shares to their policy holders) or through an inheritance? These people account for one-third of investors.
For the other two-thirds though, why stop at 2 or 3 shares? Instead of choosing to diversify and even out the investment risk of holding any one company, holding such a small number exposes you to unnecessary firm specific risk – risk that you never had to carry.
Maybe you started with just buying Telstra shares. Heaven knows when your sole investment experience looks like the blue line (which is Telstra’s share price since it listed), instead of the red line (which is the ASX200), it might be enough to put you off shares forever.
But, if that’s what’s stopping you moving forward with your investments, you’re missing out on the potential gains in the share market as a whole.
Even with the GFC, the Australian market (or top 500 shares at least) has returned an average of 13.9%… compared to the average cash rate of 8.5%.
Personally, I think it’s that no one has taken the time to teach people about how to invest in shares and how to construct a portfolio (including the benefits of owning more than 3 shares).
When you invest in the share market, you are always going to take on some level of investment risk (or uncertainty of return). It makes it a lot easier to make money when the whole market is going up, and likewise it doesn’t matter how good you are at putting together a portfolio, if the market goes down your portfolio’s probably going to go down too. [pullquote]When you invest in the share market, you are always going to take on some level of risk[/pullquote]
This risk – the risk of a market (rather than the risk of one individual company) is called “Market Risk” – and if you participate in a market, there’s nothing you can do about it. A bit like if you invest in term deposits or your savings account and interest rates go down. If interest rates are at 3%, you’re not going to be able to roll over your term deposit at 6.5% – that’s the market risk of fixed interest.
Each “sector” or part of the market has a risk. If the building industry is going poorly, the stocks associated with that area of the market are going to struggle. Likewise, if the mining sector is going gang-busters, pretty much all the mining stocks (even the not-so-great ones) go up.
This is why you might start with a “top down” approach. Chose your market, then the sectors that are either well positioned for a recovery or are going well, and then choose the best stocks in that market (as opposed to choosing one of the 2200 shares in the Australian market because you just like that company).
Each individual stock carries its own company risk, or “stock specific” risk. These might be factors like changes to laws that affect that company (like lotto companies – or Telstra), or the resignation of a manager, or a shutdown at a plant. All of these things affect that one individual company.
This is why you want to own more than one (or 3, or even 8) companies. You can actually come close to eliminating stock specific risk by diversifying the number of shares you own. By the time you hold over 20 different stocks, you’ve actually gotten rid of 93% of risk that is attributable to your individual holdings.
There is no reason to hold only 3 shares. All it results in is risk that you don’t have to have, and quite possibly returns that are sub-standard.
[Tweet “Holding a small number of shares increases risk”]
So – if you’re a one in three investor that has less than three shares, take a step to lower your risk and start building your portfolio. And if you don’t know what to add to your mix, then call me and build an investment plan that includes a properly constructed portfolio which gives you a better chance of greater returns and lower risk.