Why you should spread your investments in the current market
The old adage goes “you shouldn’t keep all your eggs in one basket”. It holds true for investing too. On the surface, that all sounds pretty easy. Don’t put all your money in one stock. Even if that stock pays wonderful dividends. Something will go wrong at some point, and you need other investments to hold fast. But diversification is not necessarily as easy as it sounds. In fact, overdiversification is a common mistake people make in their portfolios (see link).
So back to basics… what is diversification?
Diversification is about ensuring your money is spread across a range of investments, in keeping with your philosophy and strategy.
It aims to give you growth and income sources from assets that perform differently, at different points in time and with different factors driving performance.
Diversification includes spreading your investments across:
- Asset classes: equities, fixed income, property, commodities, alternatives, currencies
- Regions: look beyond Australia to the US, Europe, Asia and Africa.
- Sectors: i.e. don’t stick all your money in tech, consider other sectors like healthcare, consumer staples or materials, to name just a few.
- Investment styles: income, alternatives, contrarian, growth, value, just to name a few.
- Risk levels: some investments bear a higher risk of loss of capital, some have a lower risk. The higher risk assets tend to be growth investments, whereas the lower risk are more likely to be defensive assets.
A simple example of diversification
Sometimes the best way to explain something is to demonstrate it. So, here’s a very basic example using diversification across sectors in equity investments.
Say you put 50% of your money in Qantas (ASX: QAN) and 50% in Woolworths (ASX: WOW) back in 2019, aka BC (before COVID). One is in the Transport sector, the other is consumer staples. So completely different sectors and revenue streams. Then the COVID-19 pandemic starts.
Qantas is forced to shut operations and its share price and earnings are hit hard. Your portfolio is feeling it. But… Woolworths is thriving. Everyone is ordering their online grocery delivery, the shelves are empty of toilet paper and it’s great for share prices and earnings. It’s become a buffer for your portfolio. Maybe it’s more than offset Qantas if you are lucky. Even better, the pandemic eases, borders open and Qantas resumes operations. So you have the chance to still benefit from the change in circumstances.
Now think of again but this time, you put 50% of your money in Qantas and the other 50% in Virgin Australia Holdings Ltd (ASX: VAH). Not only are they both transport companies, but they are also both the same sub-industry – airlines. To make matters worse, Virgin bombed badly and had to be bailed out at the start of the pandemic. Things are looking far dicier for your portfolio and there’s no buffer. This is your case for diversification.
More data to back up the case
Looking at asset class returns over time also demonstrates the value of diversification.
This table from Schroders shows how key indices representing different asset classes have performed over the years, with each asset class ranked top to bottom. For example, last year, the top performer was global equities while the bottom was Australian fixed interest. But the previous year, the top performer was global emerging markets and the bottom was Australian property trusts. You can also scroll through the chart here.
Essentially, the top performer in one year is not necessarily the top in another year so having a blend of asset classes helps.
It’s worth remembering that different asset classes also typically play different roles in a portfolio. For example, fixed income investments are traditionally more defensive. That might sound odd given the current market of rising interest rates, but you need to remember that these assets can still offer a regular source of income. By contrast, equities are generally classified as growth assets so hold a higher risk potential of loss – but also a higher potential for gain.
How to diversify?
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Start with your strategy and risk profile
If you know what your goals are and what level of risk you can comfortably take on in your portfolio, then you can work out what mix of assets and investment styles are likely to help you achieve that. For example, your strategy might involve a traditional 60:40 balanced portfolio. This represents 60% growth assets, such as equities and 40% defensive assets, such as fixed income. A financial adviser can assist with this process and the ongoing management of your strategy. - Identify a blend of assets and investment styles that fit in with the strategy and avoid overconcentration into a particular sector or region.
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Regular portfolio checks and rebalancing
Market movements can mean your investments start to drift away from your strategy and ideal portfolio composition. Some holdings may grow, and others may shrink. This can change the risk profile of your strategy and mean you are less diversified than you intended. By regularly checking your investments and rebalancing as needed, you can keep it on track.
Frequently asked questions
What is diversification?
Diversification means ensuring your investments are spread across asset classes, sectors, regions, investment styles and risk levels.
Why should you diversify your investments?
Diversification aims to give you growth and income sources from assets that perform differently, at different points in time and with different factors driving performance. It means you are not solely dependent on one particular asset for your portfolio’s performance and returns.
How can you diversify your investment portfolio?
Identify your investment goals and risk profile and set a strategy to match this. Then you can identify the correct blend of investments to fit your strategy, incorporating different assets, different sectors within assets, regions, investment styles and risk levels. Ensure you regularly check your portfolio and rebalance your strategy as you need to.
This article is part of our Investment Guide series. If there is a topic you would like to learn about next, please leave a comment below.
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Sara is a Content Editor at Livewire Markets. She is a passionate writer and reader with more than a decade of experience specific to finance and investments. Sara's background has included working at ETF Securities, BT Financial Group and Macquarie Group. She also holds a degree in psychology which drives a continued fascination with how human behaviour drives and is driven by investments and market activity.
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Sara is a Content Editor at Livewire Markets. She is a passionate writer and reader with more than a decade of experience specific to finance and investments. Sara's background has included working at ETF Securities, BT Financial Group and...
Sara is a Content Editor at Livewire Markets. She is a passionate writer and reader with more than a decade of experience specific to finance and investments. Sara's background has included working at ETF Securities, BT Financial Group and...
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