Talk to any group of investment advisors and you’ll soon discover that even the experts don’t always see eye-to-eye on everything. But one thing almost all will agree on is the benefits and safeguards that come with asset diversification. It’s a principle found in the old English saying, “don’t put all your eggs in one basket”, and is followed by investors on Wall Street, superannuation funds in Australia and mum and dad investors in the Philippines.
In short, diversification is all about spreading risk across a portfolio on the understanding that, while all investments may go up as well as down, it is unlikely they’ll all go the same way, to the same extent, at the same time, and if you put all your money into one asset, a single slide could see you lose a lot.
Some assets have a lower risk of going backwards, but also less likelihood of super returns. These are commonly called, ‘defensive assets’. Riskier ‘growth assets’ have a greater potential for high returns, but also greater potential for loss.
By diversifying your investments, your plan is that, if one type of asset drops, others should stay buoyant or even increase, so losses in one asset type can be outweighed, to some extent, by gains or stability in others.
So, what exactly is asset diversification?
Different investment assets
Let’s first look at the typical assets that an investor can hold in their portfolio.
Stocks and shares are the ones that most readily come to mind when thinking about investment assets. Traditionally, they are amongst the most volatile asset types, but also benefit from the potential for superior returns over time.
Bonds are another popular type of investment, as they are typically stable and steady, though they don’t provide the growth potential that stocks do. They offer a fixed interest for a set period of time and are very similar to time deposits.
( See also: Investing in Bonds )
Cash is primarily money sitting in bank accounts. This type of asset is also seen as safe but uninspiring as it is guided by interest rates, which right now are historically low, making cash a secure but low-growth asset.
Property is regarded by some as a balanced asset (medium risk with medium potential for growth), although some specific property types such as commercial real estate, can elevate property into the higher risk category.
Gold is regarded as a safe-haven: the investment choice people turn to in times of volatility. Investments in this area include actual bullion as well as gold bonds. Many investors also include shares in gold mining or gold producing companies in this class of assets due to their obvious high exposure in the commodity. (Often when other shares go down, gold miners go up.)
Currency, while still technically cash, deals more with buying and selling different countries’ money and is a highly technical, (and high-risk) investment asset, and should be pursued only by those who really know what they’re doing.
Diversifying across asset classes
A broadly diversified investment portfolio could draw from a number of the above asset types – typically, cash, fixed interest bonds or time deposits, shares and maybe property.
Everything being equal, this type of strategy would be regarded as quite balanced as it combines the stability and security of cash and bonds, with the growth potential of shares. If the stock market crashes, all is not lost, as declines in share values can be buffeted somewhat by the fact there is still value sitting there in the cash and bonds. Of course, if the stock market soars, then the share values increase, but overall growth is held back slightly by the more conservative assets.
It’s also possible to adjust the risk by adjusting the proportions of assets held in one portfolio. For example, an investment strategy that is predominantly shares, but also contains smaller amounts of cash and bonds, is still diversified but will be more influenced by stock market volatility.
( See also: Cash, Bonds and Stocks — The Building Blocks of a Mutual Fund )
Diversifying within asset classes
A portfolio weighted towards stocks and shares can (and indeed should) also be diversified since not all companies, and therefore not all shares, are the same.
Some well-established, relatively stable stocks are often labelled ‘blue-chip’. They are typically large, well-known and often critical businesses linked to global brands. They tend to be a lot more secure, though of course never fully immune to share volatility. Their relative stability often means they don’t increase in value as quickly as their smaller counterparts, but they tend to be safer.
Smaller, emerging or innovative companies may potentially provide amazing growth, but can just as easily fail, while second-tier or mid-cap companies offer somewhat more of a balance between growth and risk.
A diversified share component could include a mix of the three.
Alternatively, the share component could be diversified across sectors on the assumption that, even in dire scenarios, some sectors will do better than others. A diversified, share-based investment plan across sectors could include a range of stocks from, for example banking, transport, retail, property companies, manufacturing, health, education and/or tech. Each sector could, at some point, see a dip but it is less likely (though never impossible, as in the GFC) that all sectors will crash at once.
It’s also possible to diversify across property investments with a mix of residential, commercial and industrial or with a mix of locations or property types. And while few people are in the position to hold their own diversified property portfolio, smaller investors can invest in property trusts and property companies that are themselves diversified, so while you don’t actually own the bricks and mortar yourself, you still have an investment in property through your shares or units in the trust – many of which can be purchased on the stock market.
Simple diversification
The great thing about diversifying is that you don’t actually need a lot of money to get started, and the two most popular ways to do this are through exchange traded funds (or ETFs) and mutual funds. In essence, they are similar in that they manage a pool of money from their investors, and invest in particular assets.
Mutual funds traditionally focus on one of three asset classes: equities (i.e. stocks and shares), fixed income (i.e. bonds), and money market (i.e. cash), however you can also find hybrid funds which span different assets. Mutual funds are generally ‘actively managed’, which means experts keep a keen eye on the relevant markets, and buy and sell parcels of shares etc. to achieve the objectives of the fund (usually maximising the returns for shareholders).
( See also: What is a mutual fund? )
ETFs are similar, in that they are a managed portfolio of assets (most commonly shares) bought and sold on behalf of a pool of investors who own shares in the ETF, which they purchased on the stock market. ETFs are managed passively, which means that the holdings of the fund are bought and sold almost automatically, based on pre-determined criteria. This means their management fees are lower than managed funds, but returns can also be lower.
Investing in this way is like buying shares in a pre-existing share portfolio. One ETF or mutual fund gives the investor diversification across a range of assets, and it’s even common for people to hold a portfolio of diverse mutual funds – all for the simple goal of buffering against loss in one asset, and ensuring all your eggs are not in one basket.
