What is diversification?

Diversifying your investments will reduce their risks and volatility, but what does it involve?

Often described as “not putting all your eggs in one basket”, diversification is crucial to reducing the volatility of investing. It’s about spreading your risks.

We know that the markets for different asset classes – such as bonds, shares, property or infrastructure – can go up and down for many reasons, but they usually don’t move in exactly the same way. While one market can be up, another can be down. That’s because different asset classes react differently to what’s happening in the economy and developments around the world.

To reduce the pain that can be caused by a fall in one market, the experts believe you should spread your risks across several markets. So, when one asset market is down, the losses may be offset by gains from another market which has been performing better at that time. For example, if shares are down, bonds may be up, and vice versa.

Indeed, it’s been found that a portfolio made up of different kinds of investments will, on average, produce higher returns and have less risks and volatility than any individual investment in a portfolio.

Diversification considerations

When diversifying your portfolio, you need to consider what risk-return trade off you are willing to accept. The asset classes likely to produce the best returns also have the highest risks. These are called growth assets and include shares, alternative investments and property investments. To spread your risks, you would mix them with defensive assets such as cash and fixed interest, which have lower risk and returns.

That said, it’s important to note that asset classes aren’t the only way you can diversify your holdings. You can diversify your share portfolio by investing in both Australian and international shares. You can go even wider by diversifying your overseas share portfolio into both developed markets and emerging markets, or by regions, such as Europe or Asia, or even by country – for example, by investing in Chinese or US shares.

Spreading your risks

The Australian share market accounts for less than 2 per cent of the value of the world’s share markets. This means you have plenty of opportunities to pick from outside of Australia. Different overseas markets are likely peak at different times, depending on their economic conditions. When the US market is in a slump, China might be booming.

Your share portfolio can also be diversified across different types of sectors, for example, financial services, mining, healthcare or industrials. And it can be spread across the size of companies, such as large companies and small companies, or by the different investment philosophies of your fund managers. Fund managers with different focuses – for example, on value or growth investing – perform better at different times of the investment cycle.

Remember that you don’t need to have millions of dollars to diversify. In addition to investing directly, you can access different countries and regions through managed funds, exchange traded funds or investment options offered by your super fund.

Similarly, your bonds investments can be diversified by country or by type, for example, government or corporate bonds. Your property holdings could include direct or listed property, or be spread across residential, retail or commercial property.

As always, we are here to help. If you have any questions about diversification please don’t hesitate to contact our team.