Diversification is a strategy favoured by many investors, as it can lower your risk and help you get more stable returns. But what is it? And how do you go about building a diversified portfolio?
What’s a diversified portfolio?
Most investments fit into one of four main asset classes:
- Cash – for example, money you have in a savings account or a term deposit
- Bonds – these are issued by governments or companies to raise money. When you buy a bond, you get paid regular interest payments
- Property – which can be land, residential property or commercial property
- Shares – partial ownership in a company listed on the Australian Securities Exchange (ASX) or a foreign exchange
Cash and bond are known as ‘defensive investments’. This means they are low-risk, provide you with predictable returns, but have little potential for capital growth.
Property and shares, on the other hand, are ‘growth investments’. This means they can give you an income (for example rent or dividends) as well as provide higher returns over the medium to long-term. Property is less volatile than shares, though your returns can fluctuate and are not guaranteed. Shares have the highest risk factor among the asset classes.
At its simplest, a diversified portfolio is when you invest in a range of different asset classes, rather than just the one – for example, owning an investment property as well as having shares and cash in the bank.
You can also diversify within each asset class. For example, our hypothetical investor above could own:
- Shares in different sectors such as technology, healthcare, retail and energy
- Different property types such as residential and commercial
How diversified portfolios minimise risk
We all know it’s risky to put all your eggs in one basket – because if something were to happen to that basket, all your eggs would be gone. Diversification applies this logic to investments. That’s because different asset classes do well at different times. So if one asset class is having a rough time, another might be making stronger returns. As a result, your portfolio is better protected from market volatility.
How to build a balanced portfolio
- Review your investments. If you want to build a balanced portfolio, you need to invest in different asset classes. To do that, you first have to figure out which asset classes you’re already investing in. Don’t forget to include your superannuation in the review.
- See what’s missing. The next step is to identify any gaps. So, if you already own shares, you might invest in property to balance out your portfolio.
- Research other asset classes. You don’t want to make an investment without doing your homework first.
Getting the right portfolio mix is an ongoing project. That’s because, over time, some of your investments will grow faster than others. As a result, your portfolio becomes less diversified. So you might need to rebalance to bring it back to its original asset mix. Everyone’s situation is different, so there is no one right way to invest. That said, getting good financial advice from a professional can help you work out the right investment strategy for you.