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Many investors are aware of the importance of having a diversified portfolio but may be confused as to whether their money is in fact diversified or not.
This guide will teach you what a diversified portfolio is and the benefits of having one. It also offers an easy 5-point checklist to assess whether your money is diversified. If it’s not, don’t worry, we also provide some advice on how to ensure it's diversified.
A diversified portfolio has a range of different assets, rather than investing in a single asset type.
For example, if you have all your money sitting in a savings account, you don't have a diversified portfolio. Similarly, a property investor who owns numerous investment properties but doesn't have any other investments, doesn’t have a diversified investment portfolio. This is because they are only investing in a single asset class (property).
But, a property investor may have a diversified property portfolio if they invest in a range of different property types such as houses, apartments and land.
The main benefit is that it minimises risk. Like the common phrase "don't put all your eggs in one basket", the same applies to investing. This is because in the unfortunate event that something were to happen to that basket, all your eggs – or money – would be gone.
If an investment class performs poorly over a certain period you will only lose money on your investments in that asset, rather than across your whole portfolio. Let's say you only invested in shares in Australian companies. Each time the market fluctuates your entire investment portfolio would be affected. But, if only one-quarter of your portfolio was in shares then only one-quarter of your portfolio would be affected.
It's also of benefit to diversify your portfolio within particular asset classes. For example, if you’re investing in shares, investing in a range of different sectors and industries will further help minimise risk to your investment portfolio as a whole.
While it has been out of fashion for a while, the 60/40 portfolio could be one way to diversify.
With a 60/40 portfolio investors put 60% of their money into stocks and 40% into fixed assets including bonds. The point of this is to have both growth and income. It is generally considered a safe way to grow your portfolio. This is because stocks give investors the growth portion of their portfolio while the bonds offer a safer secure growth portion. While theoretically true, keep in mind in 2022 both shares and bonds fell.
If your money is properly diversified, you generally aren’t concerned about what the market does on any particular day. If small market fluctuations are keeping you up at night, this could be a sign that you have too much money invested in a particular asset class.
Investors with diversified portfolios are generally in it for the long term and are investing to create future wealth. Non-diverse investors tend to invest a large pool of money into an asset for a short amount of time. If you’re investing with the intention to sit tight for the next 20, 30 or 40 years, you will likely have a diversified portfolio.
Investors who don’t have a properly diversified portfolio are likely to get caught up chasing the next big investment opportunity. They might keep an eye out for shares that are underpriced with the intention to buy and sell and make a quick buck. Diversified investors are usually more confident because they have a stable, well planned, long-term strategy.
The more asset classes you’re invested in, the more diversified your portfolio is, meaning it's also lower risk. If you have money invested in 2 or more of these asset classes, you have a diversified portfolio:
An ETF is a type of managed fund that is traded on the ASX like shares. The fund owns a range of assets including local and global shares, bonds, foreign currencies and commodities. The investor doesn't own these underlying assets but instead owns a portion of the entire ETF. So even if you only invest in ETFs, you automatically have a diversified portfolio.
For many investors, it could be tempting to put your money into 1 or 2 assets, especially if they are continuing to gain market share.
But if the price of that asset falls so does your overall wealth. Especially if they are in the same asset class.
Take for example owning shares in 2 of Australia's Big Four banks.
While an investor might say they own 2 different assets, they are likely to be impacted in the same way.
To diversify, an investor could put their money in a number of different stocks in a variety of asset classes.
In order to find out if your share portfolio is diversified you could look at whether or not your holdings are all in the same asset class.
There are 11 ASX categories: energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, information technology, communication services, utilities and real estate.
If an investor wants to make sure they are diversified through shares they don't necessarily need to have assets in all of these categories but being in more than 1 or 2 can help.
The second option for investors is to put their money into other asset classes or even international shares. This can help offset potential issues in the Australian share market.
A simple way to ensure your money is diversified is to invest in ETFs. Rather than learning the intricate details of each individual asset class and trying to asses which to invest in, an ETF will do the hard work for you. This is a great option for new investors who are just dipping their toes in the water.
If you do have experience investing in Australian shares but don't meet the the checklist above, a simple way to diversify your portfolio is to invest in some international companies. This a good way to diversify your portfolio without adding too much additional risk. In the event that the Australian economy crashed and the share price for all ASX-listed companies dropped your international shares would be largely unaffected.
Yes it's theoretically possible for you to over-diversify, which will limit your upside.
Basically, if adding a new investment in your portfolio increases your portfolio's overall risk or lowers expected returns without the benefit of lowering risks, then it does not really serve your overall financial goals.
This over-diversification usually happens when investors buy too many assets that are closely correlated.
Let's take the example of owning the Big Four banks. If you own 3 of them, in a portfolio of say 20 stocks and other financial assets, adding the fourth does not help you from a diversification point of view. It adds to your risk (all 4 banks are exposed to property, for example, so will move together) and could lower your overall return. As such, you might be better off diversifying into other stocks.
Investing should be an exciting way to help you build your wealth and set yourself up for financial freedom.
While diversification doesn't completely protect your portfolio from downturns, having a disciplined approach to investing by diversifying your portfolio can offset some of the short-term pain.
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