Diversification fundamentals in portfolio construction (Repost)

You’ve probably heard the saying, “Don’t put all of your eggs in the one basket”, but what does it mean? In this article, we explore the importance of diversification when it comes to portfolio construction.

Written and accurate as at: 9 Jun 2017

Diversification, or spreading your risk, is a key risk management strategy used when constructing a portfolio whether inside or outside of superannuation.

It’s the strategy commonly referred to as “not putting all your eggs in one basket”.

The premise behind diversification is that no one asset or type of asset provides the best performance over all time periods – they tend to rise and fall at different times depending on economic, political and market factors.

Methods of diversification

Diversification may often be achieved by:

1. Spreading your funds across a variety of asset classes. Cash, fixed interest, property and shares all have particular risk and return characteristics and typically tend to perform differently under certain market conditions. By investing across asset classes, you may be able to reduce the volatility of your overall portfolio returns.

An example of the performance of asset classes over the last 5 years is illustrated in the table below.

*S&P Dow Jones Indices.

^Past performance is not a reliable indicator of future performance.

2. Spreading your funds within each asset class across a wide range of industries and geographical regions. By doing this, you are making sure that your portfolio is not concentrated heavily in one place, which may help reduce the impact of a downturn in a particular market or region.

An example of the performance of different industry sectors within a specific asset class over the last 5 years is illustrated in the table below.

*S&P Dow Jones Indices.
^Past performance is not a reliable indicator of future performance.

It’s important to note that diversification will not ensure against loss within your portfolio, it’s about managing the risk/reward trade off by selecting a mix of quality investments to help you achieve more consistent returns over time.

Investment Mix
The overall exposure that you have to different asset classes, markets and regions, as well as how diversification will be applied, will depend on numerous factors, such as your risk tolerance, financial situation, and financial goals and objectives.

One possible way to look at your investment mix is the time frame in which you would like to be invested and what you would like to achieve from your portfolio in that given period of time. For example, if you have a:

• Long-term timeframe and wish to accumulate wealth – your investment mix may have a larger allocation towards growth assets, such as property and shares. These asset classes typically experience more volatility in the short to medium-term; however, they have a greater potential for capital growth in the long-term when compared to other asset classes, such as cash and fixed interest.

• Short-term timeframe and/or desire to generate income – your investment mix may have a larger allocation towards cash and fixed interest. These asset classes generally experience less volatility and are more focused on capital preservation (rather than capital growth), and income generation when compared to other asset classes, such as property and shares.

An investment mix is not ‘set and forget’. Different types of assets may have differing returns from year to year. Over time, if left unchecked, this may result in the investment mix moving away from the original allocation set. Consequently, regular reviews of your portfolio are important – in some instances, rebalancing your investment mix may be necessary to make sure your portfolio continues to meet your risk tolerance, financial situation, and financial goals and objectives.

Moving forward

If you would like to know more about diversification and how it relates to your portfolios, please don’t hesitate to get in contact with us.