Outline:
- Think about your existing exposure;
- Identify other industries you understand;
- Make sure you are keeping your investments broad;
- Narrow exposure could leave you suffering acute losses.
Diversification means investing across multiple asset classes, sectors and geographies to manage risk.
This reduces your exposure to any single economic event. The goal is to have a portfolio that is diversified enough to ensure that the prices of your investments do not move together perfectly, which causes volatility in your portfolio.
The proverb “don’t put all your eggs in one basket” is talking about diversification.
If one egg breaks, it's likely they all will.
Financially, the equivalent is a portfolio invested in one thing.
An undiversified portfolio is one that holds only gold companies or banks or technology stocks. A really undiversified portfolio is only holding one company.
But if that industry collapses or company disappears, so does your investment.
You lose all your eggs.
A portfolio invested in a few assets in the same asset class is diversified, (it's better than just having exposure to one company) but probably not well diversified, especially if they are in the same country.
Think about it like this — if all your money is tied up in investment properties in Australia and Australian housing prices go down, what happens?
The most important thing to remember is if all your returns are strongly correlated, your portfolio probably isn’t well diversified.
Diversification and Return
The relationship between diversification and return means a diversified portfolio will never exceed the performance of the best performing investment and will never be lower than the worst performing investment.
A diversified portfolio means you narrow the range of possible outcomes to somewhere between your best and worst expected return. You’ll never get the best or worst performance of a portfolio. It’ll be somewhere in between.
How to Build a Diversified Portfolio
To create a diversified portfolio you need to look at what asset classes, sectors and geographies you want to invest in.
For most, an ideal investment portfolio will have varying degrees of risk and return. Think growth assets like equities, and defensive assets like bonds and property.
The proportion of the portfolio given to each asset will depend on an investor’s time frame, risk tolerance and other influences. A few common asset classes you’ll see are cash, fixed interest, property and equities.
When you think about constructing your portfolio, remember you already own assets. And they form part of your portfolio too.
Think about it like this, if 90% of your wealth in invested in your home, it probably doesn’t make sense to have even more exposure to the Australian housing market.
It’s important to consider how additional investments will affect the allocation of your portfolio. Otherwise you may accidently concentrate your portfolio into a single asset class.
Within asset classes, you can diversify across industries and geographies.
For example in stocks there are data centre companies, energy companies, Australian banks etc. Different geographies and industries will perform better at different times and some sectors can be more volatile than others.
Australia is a small part of the world economy and if you only invest in Australian stocks, you rely on the performance of the Australian economy. You can reduce your exposure by choosing international investments.
That said, it’s important to understand investing in international assets comes with the additional risks like changes in exchange rates, that could improve or reduce your investment returns.
Staying Diversified
As some investments perform better than others, your investment portfolio can become overweight in an asset class and unbalanced. So, you may need to reweigh your investments over time.
How often you review your portfolio’s allocation depends on how you are investing. And in the end, it’s up to you.
Rebalancing your portfolio means you may sell assets that you have too many of, and reinvest the money back into assets that you don’t have enough of.
This can have tax implications, so it’s best to understand the implications prior to selling.
Another way of rebalancing is investing your new savings into the assets that are sitting below where you want them to be (to ‘top them up’).
Summary
Diversification is about reducing the risk of any particular event on your portfolio. To diversify, you can buy different asset classes, industries and geographies.
Your level of diversification depends on your investment time frame and appetite for risk. The goal is to achieve the best results with the lowest acceptable risk.
