Diversification is important in helping you through the ebbing and flowing of financial markets. By placing all your investments in one sector, you leave yourself vulnerable to a single economic event .
Diversifying will ensure you still have money in other businesses or sectors, so even if one fails you have security in the others. Diversification is an essential in reducing your risk of losing all your money due to unforseen circumstances.
How does diversification work?
Diversification is the investment of your money in a variety of sectors. This helps manage the risk/reward trade off by selecting a combination of investments that work together to help you realise your financial ambitions. Though diversification can’t protect you against losses, or guarantee large gains, over time it generally helps in receiving more consistent investment returns. On top of this, it allows you to spread your risk across different asset classes, leaving you in a less vulnerable position when it comes to suffering loss in the wake of bad period for one sector.
When assessing an investment opportunity, it is worth asking yourself if the investment will diversify your portfolio further. This approach will stop you from putting all your funds into a single asset class, and help you avoid making expensive mistakes.
How you can diversify your portfolio
By making investments in assets of different classes, you will create a diversified portfolio. This process is referred to as ‘asset allocation’. The ideal investment portfolio would involve a few high risk/high reward investments, while also having less volatile assets included in the mix.
A good starting point is to spread your investments across the main asset classes. These are cash, bonds, property, fixed interest, and shares. If you already own a home, buying a residential property would be poor diversification.
Deciding how to split your money will depend on what risks you are prepared to accept, and what your investment goals are. Higher risk investment portfolios may hold property and primary shares, while lower risk portfolios generally have the majority of investments in fixed interest and cash, and less than half in property or shares. The easiest way to access a broad range of investments is generally by investing through a managed fund.
Investing in different industries
You can further diversify your investments by spreading your funds within each asset class. When investing in shares, for example, this would mean spreading your funds between different companies and in a variety of industries such as finance, materials, energy, utilities, consumer goods, mining, health care, etc.
Investing in different markets
A very small share of the world’s investment opportunities lie in Australia – it is worth considering investing a portion of your money internationally. This is also useful in reducing your exposure to a single market, as international markets may rise as Australia’s falls.
However, keep in mind investing internationally has the added risk of currency exchange rates not falling in your favour, thus reducing your investment returns. On the flipside, this could end up being a benefit if exchange rates are favourable when capitalising on investments.
If you don’t have much experience in this area, it may be worth leaving international investments to your super or doing it through a managed fund. If you do have experience and want to invest overseas directly, it is still worth getting personal financial advice before finalising anything to aid in managing risks.
Time your investments
There is a chance your investments will suffer from your timing in buying or selling them. This is known as ‘timing risk’, and can happen if you buy an investment just before a price drop, or sell just before prices rise.
One way of reducing your timing risk is to invest in regular intervals, rather than all at once. In doing so, you will pay fluctuating prices for your investments, but these differences in price will even out over time. This reduces your likelihood of being caught out by bad timing, and is called ‘dollar cost averaging’. Alternatively, you can do a similar thing by selling your investments in regular intervals if it suits your needs.
Diversification Within Managed Funds And Super
Super and managed funds also offer diversified investment options, you don’t have to rely solely on direct investments like shares.
Check out your super’s investment options, as most funds will offer mixed investment options (conservative, balanced, and growth are generally available). This will allow you to diversify in an easy way through your existing super fund, who usually employ a variety of fund managers specialising in different asset classes.
If, however, you have a self-managed super fund (SMSF), you will be responsible for making investment decisions for that fund. Make sure you carefully consider what mix of investments you should make, and avoid putting all your money in a single market sector. Once you have a mix that you’re happy with, maintain it through regular check-ups and rebalancing.
It is wise not to rely on a single fund manager for the entirety of your investments, as different managers will have different strategies and styles of investing. Some managed fund providers offer multi-manager funds, which allow you to reap the benefits from a multitude of experienced managers within a single product. Thus, you only need a single fund to be diversified if that fund uses multiple managers.
Review your investments regularly
An annual review and rebalance of your investments is the least you should be doing to ensure success. It is preferable you also review your portfolio if your financial circumstances change, or you have a shift in attitude towards riskier investments. For example, you may want to consider rebalancing your investment mix if it moves away from your target by more than 10%.
How do I rebalance my investment portfolio?
Rebalancing involves selling assets you have too many of, and reinvesting the profits from them into more valuable or necessary assets. Keep in mind selling can have tax consequences, so ensure you have considered your tax situation before deciding to sell.
Another option for rebalancing is to invest any expendable income or extra savings into asset classes you’re currently lacking, or that are below target. Doing so will have no tax consequences, so may be a better option for you depending on the timing.
Remember, diversification of your portfolio will not ensure against loss, but will help even out price swings during the regular ups and downs of the market and reduce the risk of major disasters.
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