This video discusses what diversification means in practice.
The basic building blocks of establishing a diversified portfolio of investments that may include a small or large range of asset classes are explained.
Building a diversified portfolio of investments consists of buying a range of different kinds of assets, from shares and property to bonds and international assets, with a cash component kept in reserve. There are other asset classes you can add, but those are the basic building blocks.
To be properly diversified your investments have to be spread both within and across asset classes. For example, it isn't wise to have the Australian shares portion of your portfolio invested in just bank stocks, because you're only exposed to banking – which can leave you vulnerable to things like changes in interest rates. Buying BHP or Telstra adds another industry to the mix thereby providing that diversification and a cushion against some market shocks.
Also, it may be best to have some international shares in your portfolio as well, to invest in companies and industries that you can't find in Australia, and spread your investments further. This may bring a currency risk into play, which could either help or hurt the final return, but some investors actually want exposure to currencies other than the A$ – they think of that as another layer of diversification.
How much you put in each asset class will depend on your appetite for risk and your stage of life. Risk is simply the other side of return. It’s a good idea to use a risk profile calculator to determine your investment risk profile. There are many websites on the Internet that have these.
Some asset classes are considered ‘defensive,’ because they’re less risky – for example, cash and bonds. But for the greater safety, they usually offer less return. Conversely, the so-called ‘growth’ assets, such as Australian and international shares, and property, are more volatile and risky in the short term, but provide the potential to grow your wealth over the long term.
So you also need to be diversified between ‘growth’ and ‘defensive,’ with the proportions depending on your appetite for risk and your stage of life.
Diversification is not simple, so we recommend you seek financial advice before making any decisions about your investments, to ensure your choices are appropriate to your personal objectives, financial situation and needs.