The word diversification crops up in many contexts. You might hear a business person talk about diversifying revenue streams, or a footy fan mention a team’s need to assemble a group of players with diverse skills.
In a variety of arenas, people agree that diversification can improve chances for success. Investors are no different. In a recent survey of nearly 2,000 self-managed super fund investors, about 76 per cent agreed that it is important for their SMSFs to be diversified across different investment types. Yet only 39 per cent say their portfolio is very well or well-diversified.*
That’s not especially surprising. Closing the gap between theory and reality is always a challenge. Just as it’s easy to promise yourself to eat healthily but still sit down to steak, chips and ice cream too often, it’s easy to agree on the wisdom of diversification but not be certain that your portfolio achieves that goal.
Diversification protects against the risk that a share, bond or asset class will fall in value and generate losses that will prove difficult to recover from. Today’s soaring tech share could be tomorrow’s bankruptcy. By expanding the number and type of shares and bonds you own, you increase the odds that parts of your portfolio will hold their value when others fall.
A diversified portfolio is divided among asset classes such as shares, bonds and cash to achieve investors’ required returns within the limits of their risk tolerance. This formula will vary depending on an individual investor’s age, risk tolerance, time horizon and goals.
As you examine your investments, keep these diversification concepts in mind:
- Your asset allocation, the way you divide your portfolio between different asset classes, is one of the biggest drivers of long-term performance. In other words, the specific shares or bonds you choose matter less than how much of your portfolio you devote to each of those asset classes.
- Bonds are a crucial way to diversify against the risk of the share market. A portfolio invested 100 per cent in shares generated an annualised average return of 10.5 per cent over 80 years, according to Vanguard research**, but lost more than 40 per cent in its worst year. In contrast, a portfolio divided evenly between shares and bonds returned 8.3 percent on average per year, but lost only about 20 per cent in its worst year.
- Investors should diversify both across and within asset classes. Once you have decided how much to put in each asset class, you should figure out how much to put into subsets of those asset classes. A diverse share portfolio, for example, should include allocations to small, medium and large companies and include international shares.
- Remember to examine your entire portfolio. If you have multiple super, or other investment accounts, consider them as a whole.
- Once you have chosen an asset allocation, the ups and downs of financial markets may throw it off course. Remember to rebalance to your initial allocations to stay on course or choose a fund that does this for you.
*2019 Vanguard/Investment Trends SMSF Report
**Vanguard Portfolio Construction for Taxable Investors
Written by Robin Bowerman
Head of Corporate Affairs at Vanguard.
13 August 2019