Why and how to diversify your investments

30 August 2017

This is the golden rule of managing risk, which is more real today than ever, writes Alan Hartstein.

Globalisation is intertwining markets more than at any other time, making investors the world over more susceptible to volatility. At the same time, lower returns are forecast across all major asset classes except global equities over the next decade.

It's an age-old adage for a modern age to mention the risks associated with putting all your eggs in one basket, but asset diversification has never been more pertinent given risks associated with investing exclusively in one market sector.

The aim of diversification investments should always be to manage the inevitable ups and downs of each of your asset classes, protecting you from violent fluctuations in one while being able to take full advantage of growth in another.

To be able to diversify you need a clear and concise understanding of what an effective diversified asset portfolio looks like and how to create one in a way that protects your wealth and delivers maximum long-term returns. 

The safety factor

The beauty of diversification is that it insulates investors from a major economic calamity, such as the global financial crisis of 2008 or a natural disaster such as the 2006 Boxing Day tsunami, far more effectively than if all your assets are tied up in one company or even one market sector.

At the same time, as an investor, you need your money to actively work for you if you want a good standard of living and a comfortable retirement, so plonking all your hard-earned into so-called safe havens often means you're trading safety for returns, seriously affecting your ability to maximise earnings.

Peter Foley, director of financial planning firm Thirdview, believes diversification is vital because nobody has a crystal ball and any other course of action is fraught with danger, regardless of what’s going on in the larger world.

“Over the past 30 years we’ve had stockmarket meltdowns, the Japanese tsunami and the Asian currency crisis, to name but a few events,” he says. “We’ve also had hugely successful ASX floats of major companies and a mining boom. The investor sees what’s in front of them and can be easily alarmed because things often seem far more stark at the time, but geopolitical events should not influence long-term strategic investing. Very few people, even experts, have the ability to pick market movements regularly on a short-term basis.”

ANZ Wealth chief investment officer Mark Rider adds that it’s important to look at the characteristics of an investment and how it correlates with your overall portfolio.

“You may have a number of different investments but if they all move exactly the same way over time you haven’t achieved real diversification,” he says. “During the GFC, people thought they were diversifying by investing in emerging markets and small caps, but they all had the same level of volatility.”

Why diversify?

The obvious upside of diversification is that you have other investments to offset losses if a certain company or sector performs badly. For this reason alone, Foley believes that investors should diversify over a range of sectors, asset classes, regions and even countries if there is a good opportunity to do so.

“This seems like an easy concept to understand, but knowing where to allocate your funds can be complicated,” he says.

This is compounded by the current cost of property in Australia and the fact that most Australian investors are typically overweight in this asset class simply because they need to be highly leveraged just to be in the market. While booming prices and record low interest rates have been great for property investors up to now, this is not going to last forever.

Being overweight in local property is also dangerous, Foley adds, as some investors immediately assume they can just jack up their rents whenever interest rates rise. If rents stay low due to competition, however, you may need to suddenly find large amounts of money from your own budget to service the loan on that investment property.

ANZ's Rider agrees that property investing can lead to an over-concentration in an investment portfolio.

“The danger at the moment with property is that the market has been running very strongly for some time now, so you need to consider how much longer that is likely to continue for,” he says.

The perfect portfolio

The optimal level of diversification will always depend on your individual circumstances but Foley recommends allocations across a range of asset classes that may include fixed income, bonds, cash, property and hedge funds.

“All of these come with their own risk/reward profiles so it’s important to understand any asset class before you invest in it,” he says.

Unlisted property funds and industry super funds, for example, have different return structures to listed funds and retail super.

“Historically, there has been a reasonable correlation between higher risk and higher return but it’s far from perfect and you need to be comfortable with your own level of risk in your asset portfolio,” Foley says.

Additionally, alternative asset classes such as exchange traded funds and listed investment companies offer you exposure to particular market sectors without you having to do the research yourself.

These funds are run by sector experts and Foley recommends taking on a manager as well as asset diversification when the situation calls for it. “You don’t need to have only one manager for your equity assets if you can pick best-of-breed managers across sectors,” he says.

How many assets or equities?

There is also no ‘right’ number of assets or equities to hold in an ideal diversified portfolio, though Foley favours 10 to 12 equities, which is less onerous to keep track of than a much larger number.

Rider advocates investing in a range of asset classes that may include property, real estate investment trusts and equities. Alternatively, there are more traditional diversifiers such as fixed-income bonds and growth equities, depending on your risk appetite.

“Fixed bonds may offer lower-than-average returns but they’re solid during market downturn periods,” says Rider.

There is also no right amount of cash to hold in a diversified portfolio. The cash rate hit a record low in 2016 and while it has rebounded slightly it’s still expected to yield low returns for the foreseeable future. The level of cash in your portfolio should depend on your work/life stage and how many years you are from retirement. If you have less appetite for risk because you only have a few years left to work, for example, it makes sense that the cash percentage of your portfolio is higher than someone in their mid-30s.

Other common diversifiers such as global property, infrastructure and private equity all have their pros and cons but it is always a good idea to talk to someone who’s an expert in these fields or do some in-depth research of your own before investing in these markets.

Alan Hartstein is a business writer and editor based in Sydney.