Diversification is an investment strategy that lowers your portfolio's risk and helps you get more stable returns. Show
You diversify by investing your money across different asset classes — such as shares, property, bonds and private equity. Then you diversify across the different options within each asset class. For example, if you buy shares, you buy across a range of different sectors such as financials, resources, healthcare and energy. You can also diversify by investing your money across different fund managers and product issuers. Diversification lowers your portfolio's risk because different asset classes do well at different times. If one business or sector fails or performs badly, you won't lose all your money. Having a variety of investments with different risks will balance out the overall risk of a portfolio. It's worth taking the time to review your investments and look for opportunities to diversify. How diversification benefits youDiversification is your best defence against a single investment failing or one asset class performing poorly (for example, the share market falling or one fund manager failing). If you diversify your investments, when some fall in value, others may rise and balance out the fall. Diversification lowers your portfolio risk because, no matter what the economy does, some investments are likely to benefit. For example, when interest rates fall, bond prices rise, while shares generally do poorly at this time. How to diversifyTo diversify well you need to invest across different asset classes and within different options in an asset class. You can also diversify by investing in different fund managers or product issuers. Review your investmentsList all of your investments and what they're worth. This could include:
This will show you which asset classes you're investing in and where you could diversify. Identify gaps and research other asset classesIf most of your money is in one or two asset classes, research other asset classes. For example, if you own a house, an investment property won't help you diversify. If property prices fall, you won't have any other investments to balance out the fall. To diversify, you could invest in different asset classes such as shares or bonds. Then within each asset class, make sure your money is invested across the different options available. For example, if you're mainly invested in one sector such as financials, you should research other sectors such as mining, materials, health care, capital goods and commercial and professional services. See choose your investments for information about different asset classes. The way your super fund invests is a good example of diversification. Check your fund's website or annual statement to see how they invest. See super investment options for more information. Invest overseasAustralia has a small share of the world's investment opportunities. Investing some of your money overseas will lower the risk of investing in a single market. For example, investments in Asian and European markets may perform well when the Australian markets falls. If you invest overseas you'll be exposed to exchange rate risk. Read more about investment risks on develop an investing plan. Invest through a managed fund, managed account, ETF or LICA simple way to diversify is to invest through a managed fund, managed account, exchange-traded fund (ETF) or listed investment company (LIC). Managed funds and managed accountsManaged funds and managed accounts can help you invest across a range of asset classes. Some managed funds and managed accounts offer pre-made diversified portfolios. These usually have the labels of conservative, growth or high growth depending on their asset allocation. See choosing a managed fund for tips on how to choose and buy units in a managed fund. ETFs and LICsETFs and LICs provide a low cost way to invest in an asset class or diversify within an asset class. Most ETFs in Australia are passive funds. These track an asset price or market index, such as the ASX200 or S&P500. See exchange traded funds (ETFs) for more on how these can help you diversify. Most LICs are actively managed funds and invest in one asset class, such as Australian shares or private equity. See listed investment companies (LICs) for more information.
Before you invest in a managed fund, managed account, ETF or LIC read the product disclosure statement (PDS). This shows you where the fund invests, key features and benefits of the fund, the expected return, risks, fees and how to complain. Keep your investments diversifiedOver time, some of your investments will rise in value and others will fall. This means you could have more money in one asset class than when you started investing. You could also be less diversified. For example, if your shares go up and your bonds fall in price, you'll have a greater portion of money 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. See keep track of your investments for how and when to review your investments. How to rebalanceYou can rebalance your portfolio by:
Selling investments will lead to a capital gain or a capital loss. See investing and tax to find out the tax impact of selling an investment. Get help with diversificationFinding the right investments can be challenging. If you need some help to build a diversified portfolio, talk to a financial adviser.
Eva diversifies her investments
Eva has $15,000 in savings and just inherited $50,000. Her goal is to grow her money so she has $80,000 in five years, for a house deposit. Eva does her research and decides to build a diversified portfolio. She decides to invest:
Eva has diversified across three asset classes. Within each, she's invested in a range of investments so if one fails she won't lose too much. She estimates she'll get a return of 5% per year. This will give her around $83,000 in five years for her house deposit. Editorial Note: We earn a commission from partner links on Forbes Advisor. Commissions do not affect our editors' opinions or evaluations.
Diversification is an investing strategy used to manage risk. Rather than concentrate money in a single company, industry, sector or asset class, investors diversify their investments across a range of different companies, industries and asset classes. When you divide your funds across companies large and small, at home and abroad, in both stocks and bonds, you avoid the risk of having all of your eggs in one basket. Why Do You Need Diversification?You need diversification to minimize investment risk. If we had perfect knowledge of the future, everyone could simply pick one investment that would perform perfectly for as long as needed. Since the future is highly uncertain and markets are always changing, we diversify our investments among different companies and assets that are not exposed to the same risks. Diversification is not designed to maximize returns. At any given time, investors who concentrate capital in a limited number of investments may outperform a diversified investor. Over time, a diversified portfolio generally outperforms the majority of more focused one. This fact underscores the challenges of trying to pick just a few winning investments. One key to diversification is owning investments that perform differently in similar markets. When stock prices are rising, for example, bond yields are generally falling. Professionals would say stocks and bonds are negatively correlated. Even at the rare moments when stock prices and bond yields move in the same direction (both gaining or both losing), stocks typically have much greater volatility—which is to say they gain or lose much more than bonds. While not each and every investment in a well-diversified portfolio will be negatively correlated, the goal of diversification is to buy assets that do not move in lockstep with one another. Diversification StrategyThere are plenty of different diversification strategies to choose from, but their common denominator is buying investments in a range of different asset classes. An asset class is nothing more than a group of investments with similar risk and return characteristics. For example, stocks are an asset class, as are bonds. Stocks can be further subdivided into asset classes of large-cap stocks and small-cap stocks, while bonds may be divided into asset classes like investment-grade bonds and junk bonds. Stocks and BondsStocks and bonds represent two of the leading asset classes. When it comes to diversification, one of the key decisions investors make is how much capital to invest in stocks vs bonds. Deciding to balance a portfolio more toward stocks vs bonds increases growth, at the cost of greater volatility. Bonds are less volatile, but growth is generally more subdued. For younger retirement investors, a larger allocation of money in stocks is generally recommended, due to their long-term outperformance compared to bonds. As a result, a typical retirement portfolio will allocate 70% to 100% of assets to stocks. As an investor nears retirement, however, it’s common to shift the portfolio more toward bonds. While this change will reduce the expected return, it also reduces the portfolio’s volatility as a retiree begins to turn their investments into a retirement paycheck. Industries and SectorsStocks can be classified by industry or sector, and buying stocks or bonds of companies in different industries provides solid diversification. For example, the S&P 500 consists of stocks of companies in 11 different industries:
During the Great Recession of 2007–2009, companies in the real estate and financial industries experienced significant losses. In contrast, the utilities and health care industries didn’t experience the same level of losses. Diversification by industry is another key way of controlling for investment risks. Big Companies and Small CompaniesHistory shows that the size of the company as measured by market capitalization, is another source of diversification. Generally speaking, small-cap stocks have higher risks and higher returns than more stable, large-cap companies. For example, a recent study by AXA Investment Managers found that small caps have outperformed large-cap stocks by a little over 1% a year since 1926. GeographyThe location of a company can also be an element of diversification. Generally speaking, locations have been divided into three categories: U.S. companies, companies in developed countries and companies in emerging markets. As globalization increases, the diversification benefits based on location have been called into question. The S&P 500 is made up of companies headquartered in the U.S., yet their business operations span the globe. Nevertheless, some diversification benefits remain, as companies headquartered in other countries, particularly emerging markets, can perform differently than U.S. based enterprises. Growth and ValueDiversification can also be found by buying the stocks or bond of companies at different stages of the corporate lifecycle. Newer, fast growing companies have different risk and return characteristics than older, more established firms. Companies that are rapidly growing their revenue, profits and cash flow are called growth companies. These companies tend to have higher valuations relative to reported earnings or book value than the overall market. Their rapid growth is used to justify the lofty valuations. Value companies are those that are growing more slowly. They tend to be more established firms or companies in certain industries, such as utilities or financials. While their growth is slower, their valuations are also lower as compared to the overall market. Bond Asset ClassesThere are a number of different bond asset classes, although they generally fit into two classifications. First, they are classified by credit risk—that is, the risk that the borrower will default. U.S. Treasury bonds are considered to have the least risk of default, while bonds issued by emerging market governments or companies with below investment grade credit have a much higher risk of default. Second, bonds are classified by interest rate risk, that is, the length of time until the bond matures. Bonds with longer maturities, such as 30-year bonds, are considered to have the highest interest rate risk. In contrast, short-term bonds with maturities of a few years or less are considered to have the least amount of interest rate risk. Alternative Asset ClassesThere are a number of asset classes that do not fit neatly into the stock or bond categories. These include real estate, commodities and cryptocurrencies. While alternative investments aren’t required to have a diversified portfolio, many investors believe that one or more alternative asset classes benefit diversification while increasing the potential return of the portfolio. Diversification with Mutual FundsCreating a diversified portfolio with mutual funds is a simple process. Indeed, an investor can create a well diversified portfolio with a single target date retirement fund. One can also create remarkable diversity with just three index funds in what is known as the 3-fund portfolio. However one goes about diversifying a portfolio, it is an important risk management strategy. By not putting all of your eggs in one basket, you reduce the volatility of the portfolio while not sacrificing significant market returns. |