Book a Meeting

Like it or not, investment and banking tend to be one of those buzzword-filled domains. When you’re talking about investment portfolios, “diversified” can often be the buzzword of choice.

But what does it really mean?

Why is it important?

And how can you know if your portfolio is genuinely diverse?

At the end of the day, the goal of diversification is risk management. By putting your investment eggs in different baskets, you reduce your exposure to any single risky investment.

This way, if things go a little bit pear-shaped in one area of your portfolio, the others should smooth out your investment returns, ultimately improving your risk-adjusted returns.

But how do you know if you’re doing it right?

Think of it this way, if you invest in numerous stocks that essentially function the same way and go up and down at the same time, you’re more likely to have more volatile ups and downs in your journey to getting returns on investment.

Essentially you’ve diversified the number of holdings you have, but this won’t get the job done when it comes to managing the risk across your portfolio.

It’s much better to get two stocks that function differently and perform at different times, with the expectation of having the same total returns over the next 10 years. You will end up with the same outcome, but the journey will be less bumpy and risky since each stock goes up and down at different times.

Signs of false diversification in your portfolio

So how do you know if your portfolio has what investment experts would define as “false” diversification?

The first of the two biggest red flags to look out for is if all your assets are alike.

An example of this would be that you’ve gone and invested in a number of different managed funds, thinking that, because they all hold different underlying securities, they are therefore fundamentally different investments.

Unless you’re looking into their objectives and ensuring that they have totally different investment strategies, chances are you’ve basically just invested in multiples of the same or very similar things.

The second red flag is if you’re letting positive returns cloud your judgment. Positive returns are good news, but you need to step back and look at the bigger picture. If everything goes up at the same time, it’s very likely that it’ll all go down at the same time too.

It all comes down to correlation, that is, the degree that which any two assets move together in tandem.

Ideally, what you want is negative correlations, meaning that your assets will move in opposite directions in response to the same event.

If you find that your assets are moving in the same direction, you have a positive one-move correlation and this isn’t a good thing when it comes to seeking diversification.

Another sneaky trap you may fall into is having a predominantly Australian-centred share portfolio. It’s great to invest locally, but you can miss out on some great international opportunities, particularly in the technology and healthcare fields.

What does it mean to have true diversification in your portfolio?

As we mentioned, true diversification comes when you have assets that respond differently to changes in the market. So, as the economy grows or shrinks, you can reduce the risk of one single investment hurting your returns by having multiple assets across different asset classes in your portfolio.

Bankrate has an excellent article about diversification. With regards to stocks, they recommend around 20-30 different stocks across multiple different industries.

But limiting yourself exclusively to stocks is neither necessary nor recommended. A truly diverse portfolio would include domestic shares, international shares, fixed-income securities, cash and real estate.

This gives your investments varying potential for gain and loss – some will appreciate rapidly, some will increase steadily and some may fall, but the important part is that they are not correlated in their fluctuations.

The best place to start on the path to effective portfolio construction is asset allocation.

By proactively balancing your allocations to different investments, you adopt what’s known as a defensive position, meaning your assets are growing, but you’re relatively well protected against drops in the market.

This is definitely where a financial adviser can help you out, guiding you in your decision-making on not only what kind of investments to make, but how much of your portfolio should be directed towards each asset.

To put this into a working example, imagine you have one person with a portfolio that includes the Commonwealth Bank of Australia (CBA) and Westpac, and another who has CBA and Apple.

CBA is a value stock in Australia within the banking and financial services sector, whereas Apple is an international growth stock within the tech sector. Therefore, unlike the first option where both assets have the same qualities, you can see diversification at work in the second option.

The two stocks occupy different roles in your portfolio and perform at different times, but your total return is likely to be the same as the first option with CBA and Westpac, though with significantly less volatility to get there.

How to achieve true diversification for your portfolio

Now you know what diversification looks like, how do you achieve it?

Well, first of all (and yes, we know we’re biased, but is it really biased if it’s true?) – you really want to start financial planning as soon as possible. Investment portfolios are not just for rich older people.

If you want real gains and true wealth building, you want to start making goals, and pathways to achieving them, as early as possible.

This is where a good financial adviser can help, looking at your current financial situation, and your goals and helping bridge the gap to where you want to be in the future. Financial advisers have their finger on the pulse of where the markets have been, and where they’re headed and can recommend suitable adjustments to your investments to maximise risk and return.

Say we have a hypothetical investor with the following set of circumstances:

Asset class: What type of investment are you purchasing? (eg. stocks, property, funds). Region: where is the investment based? Ideally, you want investments that are both local and global. Sector: what kind of business or industry are you investing in? You don’t want 100% tech stocks just because they’re the new flashy thing. Sure buy one or two, but you really want to spread yourself across a broad range of industries.

Remember the end goal here is to make sure that, if one industry or area of your investments fails, you’re not going to lose all or most of your assets. We’re never out to scare people but the concept of having your hard-earned money all disappear overnight is definitely terrifying.

The good news is, with the right plan, you don’t have to be afraid.

Diversification can be tricky, and this blog is only designed to give you a basic understanding. To find out how to achieve your financial goals, or to see if your current portfolio is diverse enough to make the returns you need and want, book a meeting with us. One of our Wealth Partners will be able to give you advice on how to truly diversify your investment portfolio.