Benefits of diversification
One of the most important principles of investing is to ensure that you have a diversified portfolio. This means ensuring that you spread your capital amongst different investments so that you’re not reliant upon a single investment for all of your returns. The key benefit of diversification is that it helps to minimise risk of capital loss to your investment portfolio.
What are some of the benefits of diversification?
Three key advantages of diversification include:
Minimising risk of loss – if one investment performs poorly over a certain period, other investments may perform better over that same period, reducing the potential losses of your investment portfolio from concentrating all your capital under one type of investment.
Preserving capital – not all investors are in the accumulation phase of life; some who are close to retirement have goals oriented towards preservation of capital, and diversification can help protect your savings.
Generating returns – sometimes investments don’t always perform as expected, by diversifying you’re not merely relying upon one source for income.
What makes a diversified portfolio?
To diversify your portfolio, you need to spread your capital across different asset classes to reduce your overall investment risk. These should include a mix of growth and defensive assets:
Growth assets include investments such as shares or property and generally provide longer term capital gains, but typically have a higher level of risk than defensive assets.
Defensive assets include investments such as cash or fixed interest and generally provide a lower return over the long term, but also generally a lower level of volatility and risk than growth assets.
A diversified portfolio means spreading risk by investing:
- across different asset classes such as cash, fixed interest, property, Australian and international shares
- within asset classes such as purchasing shares across different industry sectors
- across different fund managers if investing in managed funds.
Generally, particular investments or asset classes will perform better than others over a specific period depending on a range of factors including:
- current market conditions
- interest rates
- currency markets.
No particular investment consistently outperforms other investments.
For example, during periods of increased sharemarket volatility, your share portfolio may suffer losses. If you also hold investments in other asset classes such as fixed interest or direct property that may perform better over the same period, the returns from these investments can help smooth the returns of your overall investment portfolio.
So, by diversifying your investments, you can achieve smoother, more consistent investment returns over the medium to longer term.
Some other assets to help create a diversified portfolio
Listed investment companies
Listed investment companies (LICs) offer a simple way to spread your investments across a wide range of assets including Australian and international shares, fixed interest, unlisted companies and property. LICs are similar to managed funds, however LICs can be traded on the ASX, so you can buy and sell your investments at any time. Generally, LICs have a lower management expense ratio (MER) than managed funds.
Exchange traded funds
Another option is to invest in exchange traded funds (ETFs). ETFs are open ended investments that provide exposure to a portfolio of investments that make up a particular index such as the S&P/ASX 200 Index.
Like LICs, ETFs offer a simple way to diversify your investments and can be traded on the ASX.