Diversification is a strategy to spread your investments and lower your portfolio’s risk. This in turn helps you to get more stable returns.
You can achieve diversification by investing your money across multiple different asset classes — such as shares, property, bonds and cash. You can further diversify with different options within each asset class. For example, if you are investing directly into shares, you can buy shares from a cross section of sharemarket sectors such as financials, resources, healthcare and energy. You can even choose to invest via different fund managers and product types to further diversify.
Diversification lowers investment risk because different asset types perform well at different times. If one asset type or company fails or performs badly, it won’t impact your entire portfolio. Having a broad range of different investments with different risks balances out the overall risk of your portfolio.
The benefits of Diversification
Diversification is a risk reduction strategy that works by allocating funds in a portfolio to various different asset types to reduce correlation of returns. Different asset types perform differently over time, and having a lower correlation of returns can reduce the volatility of a portfolio. For example, fixed interest investments such as bonds may provide stable returns at a time when equities are falling, limiting the downside impact on the portfolio.
Harry Markowitz is famously quoted as saying ‘Diversification is the only free lunch in investing”. Diversification is not a perfect solution however, as during times of high market stress even uncorrelated investments can produce similarly negative returns.
Diversification protects you from a single investment failing or one asset class performing poorly and having this dominate the returns of your portfolio.
Review your current investments and assets
To review which asset classes you’re currently investing in, list all of your investments and the values. This includes cash in a savings account, shares, managed funds, property, your home, and your super. You can use this list to identify areas to diversify.
Look for gaps and find alternatives
If most of your wealth is invested in only one or two asset types, look into alternatives that can help you diversify. For example, if you already own a house, buying an investment property won’t help you diversify. If the property market falls you won’t have any other investments to balance it out. You should consider investing in different asset types like shares or bonds.
To further diversify seek multiple options within each asset type. eg if you’re mainly invested in Australian bank, you should seek investment into other sectors such as mining, materials, health care etc.
See choose your investments for information about different asset classes.
Learning about how your super fund is invested is a good way to understand diversification. Have a read of the MoneySmart article about super investment options for more information.
Diversify based on country
Australia is only a small part of the world market. You should seek to invest overseas in order to diversify and lower your investment risk. eg Investments in the US may perform well at a time when the Australian sharemarket is falling.
Read more about investment risks in the wiki entry develop an investing plan.
Invest through an Exchange Traded Fund (ETF)
A simple way to diversify is to invest through an exchange-traded fund (ETF). Read more about this in the wiki entry ETFs.
ETFs are a low-cost way to invest, and earn a return similar to a particular index or commodity. They can help you to diversify your investments. You can buy and sell units in ETFs through a stockbroker, the same way you would buy or sell shares.
To diversify across countries, asset classes, and product types, you could invest:
20% in a listed property trust that invests in Australian and overseas property, and
20% through a bond ETF
This gives you three different asset classes (shares, property, and bonds), a range of different investments types, and both Australian and International investments. This diversification will protect you in the event of a single investment performing badly.
Re-balancing your portfolio
Over time, some of your investments will rise in value and others will fall. You may end up with more money in one asset type than when you started investing, leading to less diversification. For example, if your shares go up and your bonds fall in price, you’ll have a greater proportion of your portfolio invested in shares. As shares are higher risk, your portfolio will also be higher risk. If you’re not comfortable with this risk, it’s time to re balance.
Have a read of the MoneySmart article: keep track of your investments to learn about reviewing and rebalancing your investments.
You can rebalance your portfolio by investing new money in an underweight investment, or within your portfolio by selling some investments and buying others.
Before you sell an investment you need to think about any potential capital gain or capital loss. See the MoneySmart article on investing and tax or the ATO website on Capital Gains Tax to learn more about tax impact of selling an investment.