Why diversification in investment is key

This is part one in SmartCompany’s five part Investing special report: The rules of investment. Written by SmartCompany and brought to you by Bendigo Bank.

Don’t put all your eggs in one basket. It’s a saying that dates back to biblical times and one that underpins the concept of diversification. In investment terms, diversification involves allocating investments among various financial instruments, industries and other categories.

The theory is that this reduces risk and maximises returns by investing in different areas that would each react differently to the same event.

Diversification across different asset classes

While diversification is an often repeated investment mantra, Dale Gillham, director and founder of Wealth Within, says many investors do not properly understand the concept.

“With diversification, don’t look at things like whether you are underweight or overweight in certain asset classes, you want to be overweight in a class which is the next growth phase rather than making sure you are balanced evenly over different sectors,” he says.

Gillham recommends diversifying by looking to invest in assets with two components, growth and income.

For small and medium business owners, Gillham cautions against having all your investment in your business.

“A lot of SMEs use their business as their superannuation, which to me is quite high risk, you need to create assets outside of the business,” he says.

Licensed financial adviser Doug Turek, managing director of personal wealth advisory firm Professional Wealth, says the traditional split to a diversified investment portfolio is to invest in shares, property and defensive assets .

“Beyond shares, another portfolio mainstay is the defensive part, which is traditionally things like cash and bonds. We are big fans of not tying all your defence to interest rates,” Tourek says.

“We have been very strong proponents of inflation-linked bonds as a form of interest rate diversification; these are bonds whose return is driven by consumer price increases rather than interest rates.”

In terms of property investment, most Australians buy directly or in trusts on the stock market like Real Estate Investment Trusts.

“When you buy a property trust you get exposure to lots of different properties, like office properties and retail stocks,” he says.

“When you buy direct property, because the cost is so expensive you have lots of concentration risks. Property has been a great performer, but you have to take extra care to do what you can to minimise betting all on the property market.”

Two other means of diversification Tourek cites are temporal diversification and legislative diversification.

Temporal diversification refers to spreading an investment over a period of time; while legislative diversification refers to spreading your investments across different assets and potentially countries in response to moves by governments around the world to tax in new and different ways.

“For example, it might be safer to spread your assets across different structures and not just concentrate them all in one super fund.”

Diversification in the share market

One asset class which the concept of diversification particularly applies to is the sharemarket.

Tourek describes diversification as “the only free lunch in finance”.

“If you hold 20 or 30 stocks you should expect to get the same return as somebody who holds 10, but much more reliably,” he says.

Diversification is made more difficult by the Australian sharemarket, which is highly concentrated around bank and mining stocks.

“We have one third debt, one third dirt and one third diversified, so Australians are particularly vulnerable when investing locally to not develop diversified portfolios,” Tourek says.

“Investors need to take extra steps to spread their wealth around different industries in the Australian sharemarket to make sure they are diversified. Be careful to not just invest in an index fund and work to have smaller companies in your portfolio and look further than Australian dollar investments.”

But Gillham says investors need to be careful when trying to diversify their investments.

“To me, the share portfolio is quite simple to diversify, but you have to watch out for what I call ‘de-worsification’,” he says

“There is a huge myth that the more varied assets you hold, the better the diversification and the more risks you hold.”

Gillham says in every market there are two risks involved – systemic risk and specific risk.

He describes systemic risk as the risk of the government changing the laws or rules, and this risk cannot be avoided; whereas specific risk, the risk of the specific asset you are in, can be minimised through diversification, although care must be taken.

“To do better than the market you can’t do what the market does, you can’t have 20 to 40 shares, the optimum is to hold eight to 12 shares,” he says.

“The more you add on you are actually just taking on more market risk.”

Gillham says many investors misunderstand diversification in the sharemarket and think they should have a range of shares in different sectors, whereas they should focus instead on having good quality shares.

“A lot of people try to have one telco, one bank, one insurance company. I don’t prescribe to that theory; if it is going up, put it in your portfolio,” he says.

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