Diversification is a go-to strategy for managing risk in your investment portfolio. But have you ever thought about why this is the case?
In this article, we’ll look into what diversification actually means for your investments, and identify the pros and cons associated with this strategy.
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What is diversification?
Diversification is a strategy for managing the risk in your investment portfolio, and potentially lowering the risk inherent in investing.
As the name suggests, when diversifying your portfolio, you’re spreading the money you invest across different and diverse asset classes. These can include:
- Fixed income investments;
- Property, or
- Alternative assets, such as hedge funds, cryptocurrencies, gold, or private equity.
Each one of these asset classes has its own pros, cons, and risks involved, so your investment weights will depend on what you’re looking at achieving with your portfolio.
Within each of these asset classes, you can diversify the industries in which you invest, too. So for example, instead of purely investing in shares of big mining companies, you may spread your share investments across tech, healthcare, education, and others.
You can also choose to diversify even further by investing in both the Australian and international markets. This works to spread the risk, so that if one specific economy faces a downturn, it won’t impact the rest of your portfolio.
Why should you diversify?
Diversifying your investments in this way works to effectively create a safety net for your investments. Diversifying your investments protects you against one asset class failing completely.
This enables you to safely navigate the volatility of the market. If one asset type underperforms, or even loses value, then you haven’t assigned all your money to this one asset class. Your money is also invested in a range of other asset classes that take up the slack, potentially cushioning the loss.
These other asset classes may even be growing, which at that point in time can neutralise, or even make up for, the loss in your initial asset class.
What are the risks involved with diversification?
In investment terms, the concept of risk is the chance that your investment prices are going to grow or decline. The level of risk that you face when investing stems from the volatility of the specific asset classes.
There are four main types of risk you’ll face when you invest.
1. Market/Systematic risk
Market risk, or systematic risk, is the overall risk involved with a particular market segment, or the market as a whole. Basically, it’s the volatility of the market, which is part and parcel of investing. It’s not something you can necessarily avoid, either.
Market/systematic risk is due to a range of factors, and reflects the impact of political, economic, and financial situations occurring in the world at that time. These lead to global price changes in your investment assets.
The most common forms of market risk are:
- Currency risk, or fluctuations in the exchange rate
- Commodity risk, such as price changes in things like oil
- Interest rate risk
- Equity risk, which informs the changes in stock price
Market risk is notably seen in the form of recessions, interest rate changes, or natural disasters. It’s mostly an unpredictable thing, so there’s no real way to protect your investments against it.
However, you can still put systems in place to prepare yourself, and the best defence against systematic risk is to diversify your portfolio.
2. Liquidity risk
As well as market risk, you’re also faced with liquidity risk. This is the risk that you can’t sell your investment at a price point that’s viable, and therefore you can’t turn that investment back into cash. You may be forced to sell your investment at a lower price—or not at all, in the case of an exempt market.
3. Longevity risk
Longevity risk is one that can keep people up at night: the risk of outliving your savings and investments. This risk grows as you near retirement, and even more so when you’re retired.
Concentration risk is effectively the risk associated with not diversifying your portfolio. It’s the risk of concentrating your money in one specific investment type. You’re open to all sorts of risk within that specific asset class, across the entire market. Concentration risk can be combated by diversifying your portfolio.
The drawbacks of diversifying your portfolio
While diversifying your investment portfolio has many benefits, it’s also important to be aware of the downsides of diversification. These may change how you choose to invest your money.
The main drawbacks of diversifying your portfolio are:
- It can feel too complicated
- Your portfolio is less concentrated, as you’re spreading your money across a wider range of assets. Over-diversifying your portfolio in this manner can lead to lower-quality investments
- Lower-quality investments can lead to below-average returns, as you’ve mixed lower-quality investments in with your good investments.
But with the right advice, a properly diversified investment portfolio can avoid these pitfalls, and make up part of a clever investment strategy.
Rebalancing your portfolio
Over time, your investments will grow and evolve with the market. Some may rise in value, some might fall, some might move along consistently. And, as your investments grow, this means that you’re going to have a smaller or larger percentage of your money invested into that specific asset class.
So if you identify that your portfolio is invested more heavily in one asset class than you’d like, it’s time to rebalance. This is achieved by simply investing money into an asset class that you want to pursue instead. Or, alternatively, you can sell off investments in the asset class or classes you feel is now over-represented.
However, when you rebalance your portfolio, this can lead to capital gains, which leads to capital gains tax. It’s not necessarily a dealbreaker, but it’s something to be aware of.
The final word
While there are some potentially negative aspects of diversifying your investment portfolio, on the whole, these can be negated by careful planning. When undertaken correctly, a diversified portfolio:
- Can be a safer investment option, as your investments aren’t all focused in one asset class
- Can hedge against risk. By diversifying where your investments are held, your range of investments have the potential to work together to cushion any specific losses
- Allows you to invest where and how you see fit.
This is why diversifying your portfolio is a good investment strategy. It enables you to take advantage of different market segments where and when you can, and manages your money in line with your financial goals. It allows you to focus on today, while planning for the future at the same time.