Editor’s note: This article contains information only. It is not intended as general or personal advice. Your Money recommends seeking professional advice specific to your personal circumstances.
When it comes to the fundamentals of good investing, there are perhaps none more important than diversification.
So why is it important to diversify your portfolio and how do you go about it?
What is diversification?
Diversification refers to having an adequate variety of investments in a portfolio. This helps to minimise losses and ensure you have exposure to profitable investments during periods of volatility
Simply put, it’s about ensuring that your money is spread between different and uncorrelated investments so as to reduce your risk.
Year to year, different markets and different investments perform with varying levels of success.
“Good stocks and markets don’t last forever,” Stockspot founder Chris Brycki said. “Usually when some things go down, other things go up and that’s why diversification is great.”
If you have all your money invested in Qantas for example, and the airline was to collapse, you could have your net worth wiped out in a matter of seconds.
While that’s an extreme example, it highlights how vulnerable your investments are if too concentrated.
Many Australians, for example, tend to invest in the same handful of stocks, according to Shaw and Partners senior investment adviser Adam Dawes.
“I get a lot of clients that come in with very big positions in CBA [Commonwealth Bank], very large positions in BHP [Biliton], in Macquarie [Bank], in CSL,” Dawes said.
“They’ve done well but they’re not diversified. I say to them that with the banking royal commission CBA fell 15 per cent,” he said.
Likewise, a housing crash in your city could turn an otherwise successful investment property into a million dollar liability.
Conversely, while it can be tempting to increase your stake in a profitable venture, that’s not always a great long-term plan.
“Over market cycles, there are periods where one particular stock will have a great run or one particular market will have a great run…but prices tend to go back to the average over time so it’s worthwhile having investments in your portfolio that will rise when others fall,” Brycki explained.
Whatever the scenario, diversification ensures your money is spread around enough that losses are smoothed out.
The first step to successfully diversifying a portfolio is understanding the broad boxes that assets are placed within. They are:
- Fixed income and bonds
Different asset classes are uncorrelated meaning that the performance of one does not influence the performance of another. eg. declining property markets don’t necessarily hurt the stock market.
Having a portion of your portfolio exposed to the bond market or gold, for example, helps alleviate some of your risk and reduces your losses in the event of a stock market slump.
Importantly it also means you profit from a run-up in an asset class you would have otherwise missed out on.
Even within an asset class like shares, it’s important to spread that investment around – again, something Australians don’t tend to do according to the Australian Stock Exchange (ASX) business development manager Rory Cunningham.
“Unfortunately most of those investments, the research shows, are held in either the big banks, the big miners and/or cash…that’s not a diversified portfolio,” Cunningham said.
A fall in commodity prices, or the divestment of funds from coal miners, for example, could wipe billions from the market cap of a large portion of the mining sector.
The financial services royal commission, for example, saw all the big banks fall collectively across 2018.
As of mid-December, Westpac and NAB had both fallen around 20 per cent throughout 2018, while ANZ and CBA had fallen about 15 per cent.
For that reason, Australians should consider different sectors like healthcare, energy, utilities and technology to own alongside others like financial and materials.
Again, at the heart of diversification is the need to hold investments that won’t all be affected by the same risks factors, and that includes geographic risk.
“We’re all very Australian-centric [investors],” Shaw and Partners senior investment adviser Adam Dawes said.
“Being diversified means having some international holdings as well,” Dawes said.
If Australia was to enter a recession and the stock market crashed, for instance, those same investors could watch their money disappear while elsewhere markets might be thriving.
“Having a portfolio of just Australian shares that you recognise is actually quite dangerous because they’re all exposed to one economy, our economy,” Brycki said.
Apart from minimising downside, diversification is also about having access to rallying markets elsewhere.
“The Australian sharemarket has been one of the worst markets since the depths of the  financial crisis. The US sharemarket has risen 300 per cent [but] our market is a little under 100 per cent so that’s 200 per cent of returns that a lot of Australians have missed out on by ignoring global stocks,” Brycki explained.
For a stock market, one of the easiest ways to get international exposure is via an exchange-traded fund that mirrors an index, like the S&P 500 in the US for example.
Applying the same principle to real estate, if you owned property outside of Sydney or Melbourne over the last decade, you might have been kicking yourself as property prices in both cities shot up.
A diversified portfolio
While the exact makeup of a portfolio will depend on a range of factors, including your appetite for risk, a truly diversified one should be inoculated from single market events.
One made up of a healthy variety of bonds, property, cash, gold and shares across different sectors and geographies will mean that even the impact of a global recession on your portfolio will be minimised.
Watch the full segment above.
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