Understanding Diversification
Understanding Diversification

Diversification is a key investment principle used to manage investment risk within a portfolio. The phrase ‘Don’t put all of your eggs in one basket’ is the key ethos of portfolio diversification.

Diversification of your investment portfolio is the widely-held strategy of investing in a large variety of assets that each have their differences in performance over time. There are different ways to diversify your portfolio such as:
  • Investing in a broad range of asset classes including riskier ‘growth’ assets (e.g. shares and property) and more reliable ‘defensive’ assets (e.g. bonds and cash)
  • Investing in a range of international assets in conjunction with Australian assets
  • Investing across different types of securities in a broad range of sectors

The Value of Diversification

Diversification gives you access to the growth and performance of more aggressive investments while balancing these with the lower volatility of more defensive investments, smoothing the return profiles and reducing the impact of market fluctuations over time. This means that you can avoid taking large risks in one asset class that may underperform, and maintain steady long term growth.
Diversification reduces the adverse effects of your portfolio relying on the performance of a small range of assets. It instead allows you to expose your portfolio to a spread of assets including both ‘growth’ and ‘defensive’ assets, while providing a smoother, more consistent profile of returns over time.

How Diversification Works

An important element of diversification is to ensure that the assets you invest in aren’t highly correlated with each other, while the returns of all assets are correlated to some extent, the lower the correlation, the greater the level of diversification.
History suggests that there is no one asset class that can consistently out-perform the others. Therefore, it is important to spread your investments appropriately. The table below demonstrates this:

Note:  Balanced fund assumed asset allocation is as follows: Australian shares (36%), A-REITs (7%), global shares (27%), Australian bonds (15%), global bonds (10%), Cash (5%). Where International fixed interest indices were unavailable, the allocation was switched to Australian fixed interest.
Indices used are as follows: Australian shares - S&P/ASX 300 Accumulation Index, International shares - MSCI World Ex Australia Index (net. Div. Reinvested) AUD, Australian fixed interest – S&P/ASX Australian Fixed Interest Index, International fixed interest - S&P Global Leveraged Loan Index AUD TR Hedged (note, index only in place since May 2013. Estimated $120 invested at that point), Listed property (REITs) - S&P/ASX 300 A-REIT Accumulation Index, Cash - RBA Bank Accepted Bills 90 Days

As we can see, an asset class which outperforms one year isn’t guaranteed to repeat that performance, and may underperform the following year. For example, in 2013 Australian listed property underperformed compared to other growth asset classes, but was the best performing the following year. This highlights the variation in returns asset classes can experience, and reinforces the value of diversification, and of holding a diverse portfolio over the long term.  
Including a variety of assets in a balanced portfolio has historically allowed for investors to make more reliable returns over time.

Effectiveness of Diversification

It is important to remember that although diversification can greatly reduce the level of risk in your portfolio, it cannot eliminate it entirely, and your portfolio is still likely to experience variations in returns. However, a properly diversified portfolio can provide a lower level of volatility in these fluctuations, and reduces the downside risk of a single asset class performing poorly.
While the benefits of diversification can vary over different lengths of time, over the long-term, a well implemented diversification strategy has proven to be the most consistent and reliable method, of building long-term wealth.

Speak to your Adviser about the diversification of your portfolio to establish the best strategy for you.  

This article is intended to provide general advice only and has been prepared without taking into account your objectives, financial situation or needs. Therefore, before acting on any information contained in this article, you should consider its appropriateness having regard to your objectives, financial situation and needs.