How to effectively diversify your portfolio

As an investor, you understand that diversification is key to protecting and growing your wealth, but are you applying it effectively? There’s a lot more to this vital strategy than "don’t put all your eggs in one basket."

Diversification can lower your portfolio’s risk and volatility and boost its ability to generate returns while preserving your capital.

Or as David Swensen, the legendary late chief investment officer of Yale University’s multi-billion-dollar endowment fund, put it:

“If you diversify your portfolio for a given level of return, you can generate that return at lower risk. If you diversify for a given level of risk, you can generate higher returns.

So, diversification is this great thing, it’s a free lunch, it’s something that everybody should embrace.”

Risk and return

Investors are often advised to begin diversifying by allocating their capital across a range of both ‘growth’ and ‘defensive’ asset classes. Yet for all their popularity, these terms are rather vague and potentially can be misleading.

To ensure diversification is really working for you requires a close examination of each of your assets to assess how it relates to all your other holdings, as well as to your unique personal circumstances and financial goals.

• Growth assets: are traditionally understood to be those that are riskier but provide the potential for capital appreciation over time.
• Defensive assets: are held to be those which generally retain a more stable capital value, while delivering reliable income streams.
• Shares and property investments: are commonly quoted as examples of growth assets, which can generate long-term capital growth to protect against inflation and low interest rates.
• Cash and fixed-interest securities (e.g. government and corporate bonds): are traditionally thought of as defensive holdings. They can provide a degree of liquidity to help meet both regular and unexpected drawdowns, while also helping to reduce the overall volatility of your portfolio.

As the Australian Securities and Investments Commission (ASIC) says, “a higher growth option will have higher risk and experience more volatile returns over the short term. But it will usually achieve higher returns over the long term. A conservative (i.e. defensive) option will offer lower risk but lower returns over the long term”.

It’s all relative

A well-diversified portfolio should include a mix of growth assets along with more defensive assets, but in today’s complex investing environment it’s essential to dig deeper than these simple categories and examine the underlying risk factors of each asset.

For example, there are multiple types of property investment available, ranging from listed vehicles (such as Real Estate Investment Trusts, known as REITs) to unlisted property investments (e.g. property trusts) and a wide range of direct property options.

Each of these options offers quite different risk profiles. Many listed REITs have a high correlation with share markets and offer relatively limited protection in the event of a downturn in equity prices. Many property trusts perform like fixed-income investments in that they provide relatively stable capital values and consistent, competitive distributions across the ups and downs of short-term economic cycles.

As the pool of potential asset types available keeps growing, so do the possible matters to consider when factoring into your decision-making process.

Asking whether investments in hedge funds, commodities, cryptocurrencies or derivatives are growth or defensive provides few useful answers, so how do you decide what you should include in your portfolio?

The right fit

Economist Harry Markowitz is credited with helping to develop modern portfolio theory (MPT), for which he was awarded the 1990 Nobel Prize in Economics. MPT has a complex mathematical foundation, but its key insight is quite simple:

An asset’s risks and returns should not be assessed in isolation, but by how they contribute to your portfolio’s overall risk and return.

An important implication of this is that you need to ask yourself (or your financial adviser): what risk does each of your investments expose you to, and how does that correlate with the risks of all your other holdings?

A property investment such as a rental apartment, for example, may be more appropriately thought of as a growth asset by an investor who has a large proportion of their wealth in Australian government bonds but may perform more like a defensive asset when purchased as part of a portfolio heavy in speculative-grade ‘junk’ bonds.

Types of risk

Not all risks are the same. Apart from managing your overall risk levels, diversifying your holdings in a way that avoids concentrations of specific types of risk can also benefit your portfolio substantially.

Types of investment risk include:

• Interest rate risk: Interest rate changes reduce your returns or cause you to lose money. This is a key risk for fixed investments.
• Market risk: An investment falls in value because of economic changes or other events that affect the entire market.
• Sector risk: An investment falls in value because of events that affect a specific industry sector.
• Currency risk: Currency movements impact your investment and returns. This is a key risk for overseas investments, Australian companies with overseas operations and investments that have foreign currency in them.
• Liquidity risk: You can’t sell your investment and get your money when you need to without impacting the price in the market.
• Credit risk: A company or government you lend to could default on the debt and be unable to make the repayments.
• Concentration risk: If your investments aren’t diversified, poor performance in one investment or asset class can significantly affect your portfolio.
• Inflation risk: The value of your investments doesn’t keep pace with inflation.
• Timing risk: The timing of your investment decisions exposes you to lower returns or loss of capital.
• Gearing risk: Using borrowed money to invest can magnify your losses. Your investments may fall in value but you still have to pay the remaining loan balance and interest.

Source: moneysmart.gov.au

By allocating your investments across a range of both growth and defensive asset classes; diversifying well within each asset class, and avoiding undue concentrations of specific risk types, you can ensure that the power of diversification is working for you. For example, while an investment in a rental property may incur little concentration risk or liquidity risk for a wealthy investor with a large portfolio that includes many other holdings, the same investment could score very highly on these risk metrics for someone with few other assets to their name.

If you’re unsure whether your portfolio is well-diversified, consider seeking professional advice from a licensed financial adviser.

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