Investment Fundamentals

Diversification

The benefits of multi-layered diversification

Background

Diversification is simply the act of spreading your SMSF account balance across a variety of assets (or asset classes), rather than investing in just one or two assets. It is one of the simplest yet most powerful ways to manage the risks we highlighted in the previous articles.

When done correctly, diversification enables investors to effectively smooth out the overall effect on their portfolio of the inevitable ups and downs of individual investments. It also reduces the exposure to any single risk or event, so that if one single investment isn’t performing well, it won’t result in a large loss of money.

In a nutshell, the core purpose of diversification is to reduce the overall risk and volatility of returns in an investment portfolio.

How does it all work

Remember how we talked about the relationship between risk and reward in the previous articles? Well, diversification is all about using those different risk-reward relationships both across asset classes and within asset classes (i.e. by using a spread of investments and investment types) to try and create portfolio returns that are more consistent and smoother over time and less prone to big, steep losses.

To accomplish this, diversification is used in a multi-layered way when constructing a solid SMSF investment portfolio.

Layer 1: Using Growth & Defensive assets

We wrote in the previous articles about Growth assets (such as shares, property etc), and how they are generally considered to offer the highest returns over the longer term. So it would be natural for investors to be attracted to these types of assets. However, recall that the flipside was that they carry higher risk and have more short term volatility.

One of the fundamental principals of diversification at the portfolio level, is that investors can reduce this risk and volatility by including Defensive assets. Recall those are the ones (like fixed interest etc) that have may have lower long term returns, but also carry less risk and volatility.

So to create a diversified portfolio, an investor can start by investing across both Growth and Defensive assets, as this will include investments with the higher risk / reward (growth assets) and investments with the lower risk / reward (defensive assets).

The proportion of growth vs defensive assets – or in other words, the net overall balance of risk / reward across the portfolio – that is appropriate will be dependant on your goals, your time frame, and your risk tolerance, and is the subject of our article in the Portfolio Construction section – the art of asset allocation.

Layer 2: Diversification within growth & defensive assets

The second layer of diversification that can be used is within each category of Growth & Defensive assets.

For Growth assets, the most common asset class used is shares. However others that may be considered include commodities, unlisted property trusts that invest in direct properties, and alternatives such as hedge funds.

With Defensive assets, the most commonly used asset class in SMSFs is cash and term deposits, however it can also include fixed interest such as Government bonds and corporate bonds.

Layer 3: Diversification within each asset class:

Once you’ve diversified between growth and defensive assets, and then between different types of growth and defensive assets, you can reduce risk further by diversifying within each asset class.

Lets look at a couple of examples.

Shares:

Diversify the number of shares held:
You can do all the research in the world, where all the numbers stack up and you are very confident in investing in a company’s shares – only to find that it just doesn’t pan out the way you thought it would. Perhaps they report a big profit downgrade and the share price drops substantially, or goes bust completely. Ensuring you have a limited exposure to that single company mean you live to fight another day. It is generally found by researchers that holding approx 12 to 15 stocks provides the benefits of diversification without giving up a large amount of the potential return of a more limited portfolio.

Diversify with global shares:
Australia is a small percentage of the global share market, and as such represents a limited selection of opportunities. Investing in international share markets can reduce single market risk, and can tap into the fact that some countries may be in a growth phase when Australia is not. This can be done either by investing in offshore markets directly, or via a managed product such as an ETF or managed fund. Note that currency exchange rates may be a factor that affects your ultimate returns in global shares.

Diversify with different industries and sectors – cyclicals vs defensives
Just as different asset classes can out-perform at different times, so it is with different industry sectors within the share market. The share market can be broadly split into two buckets. The first is known as “cyclicals”, and includes sectors such as industrials, financials, materials, energy, and consumer discretionary.  The other is “defensives”, and includes utilities, property trusts, infrastructure, and consumer staples. These sectors tend to out-perform at different stages of the economic cycle, and a diversified blend of these sectors can reduce the risk of being heavily in the wrong sector at the wrong time.

Fixed Interest:

Diversify with both Government & corporate bonds:
Government bonds have been a staple of fixed interest investing for many years, as they provide the typical balancer in a portfolio for shares, due to their general outperformance when shares are struggling. However, high quality corporate bonds can also provide this mechanism, yet often with a higher income yield due to the higher implicit risk that companies carry compared to Governments.

Diversify with fixed vs floating rate interest:
Government bonds and most corporate bonds come with what are known as “fixed” interest payments, meaning that the regular amount paid does not change over the life of the bond. The flip side of this is that when general interest rates change, the capital value of the bond may change, either up or down. If interest rates go up, fixed rate bond prices tend to go down, and vice versa.

A word on managed investments

Using managed investments such as ETFs, LIC’s, and managed funds, can be an advantageous way to access certain markets and strategies that an investor cannot otherwise access.

Just as there are benefits to diversifying direct investments, there can be benefits to diversifying managed investments. Different fund managers can use different investment methodologies and have different styles, and it can be of benefit to blend these together so as to reduce the risk of one method or style getting it wrong.

Summary

In a nutshell, the core purpose of diversification is to reduce the overall risk and volatility of returns in an investment portfolio.

This can be accomplished by spreading investments in a systematic way across different investment types, and within each asset class itself. It wont necessarily guarantee against a loss, but it will increase the probability that returns over the long term are smoother and the overall risk and volatility are lower than they would otherwise be.

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