The basics of portfolio diversification

Date: 05 October 2016

We have all heard the old adage – “don’t put all your eggs in one basket”- well, investing is no different.

By spreading invested funds across a number of different assets you can reduce the overall risk for your portfolio, as you’re not relying on only one or two assets as your investment.

It’s called ‘diversification,’ and while it doesn’t guarantee that you won’t make a loss if the general direction when markets are down, it can reduce the risks associated with investing.


What is diversification?



The world changes every day: unpredictable political, social and economic factors can move markets very quickly and not all markets react in the same. It is best to spread your risk over multiple markets and assets so your whole portfolio does not get caught in any single negative event.

The aim is to hold assets that do not always move up and down together all the time. This is called low correlation – as one investment doesn’t perform, hopefully another investment in your portfolio goes up and therefore creates a balanced result for the portfolio overall.

On any day, some of your assets may win, some may lose, but overall the result should be that the portfolio rises in value in the long term.

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How to get diversified



There are many paths that can be taken on the road to building and growing a diversified investment portfolio. Balancing risk, cost and time in achieving an investment diversification requires careful thought.

Getting adequately diversified takes a bit of effort. If we’re talking about shares, professional investors will generally try to minimise their risk by holding about 40 stocks in their portfolios.

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Diversification in superannuation



Diversification is a critical part of superannuation, all along life’s journey.

When you're younger and working, the focus of super is on generating wealth, so the ‘growth’ assets are expected to do most of the work. Growth assets can be more volatile and “risky,” so diversification is critical.

As you get closer to retirement, the emphasis moves to the ‘defensive,’ safer assets, to protect the wealth you've built. While volatility and risk may be lower the time you have available to allow assets to recover from an unexpected fall is much shorter. Once again, diversification is critical.

As you move into retirement, the focus shifts to maintaining wealth and generating income from your capital; but because you may also be drawing down on funds, capital losses such as those experienced in the recent GFC can be devastating.

Also, because people are living longer, their capital must last them longer. Therefore, you'll still need some investments in shares, property and international shares even in retirement, to replenish your funds. Because shares and property can be more volatile, diversification and suitable mix of growth and defensive assets remains a priority.

The type of super fund you choose may impact the type of investment strategies and options to which you'll have access. Some funds have higher exposures to different kinds of assets: for example, industry funds usually hold more in direct investments such as property and ‘alternative assets’ such as infrastructure, than retail funds which tend to hold more in shares and fixed interest.

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Diversification in practice



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 Australian dollar – they think of that as another layer of diversification.

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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.