Investment Diversification: How to Diversify
When it comes to investing, it can be tempting to focus on finding the investment that will deliver the strongest return.
But predicting which company, industry, asset class or market will perform best from one year to the next is difficult. That’s where investment diversification comes in.
Diversification involves spreading your investments across different assets rather than relying too heavily on one investment or one part of the market. The idea is simple: if one area of your portfolio performs poorly, other investments may respond differently.
It doesn’t eliminate investment risk or guarantee positive returns. Instead, diversification can be one way of managing risk and building a portfolio that reflects your financial goals, timeframe and circumstances.
In this article, we explain what investment diversification means, some of the different ways a portfolio can be diversified and where options such as exchange-traded funds (ETFs) may fit within an investment strategy.
What is investment diversification?
Investment diversification means spreading your money across a range of investments rather than concentrating it in one place.
There are several ways a portfolio may be diversified, including across:
- different asset classes
- industries and sectors
- Australian and international markets
- individual companies
- investment styles and fund managers.
For example, a portfolio invested entirely in Australian shares may contain many different companies but still be heavily exposed to the performance of the Australian share market.
Similarly, owning shares in several companies from the same industry may provide less diversification than it initially appears.
True diversification involves looking at how the different investments within your portfolio work together rather than simply counting how many investments you own.
Why is investment diversification important?
Different investments respond differently to changes in economic conditions, interest rates, consumer behaviour and financial markets.
One asset class or industry may be performing strongly while another is experiencing a downturn. These positions can also change over time.
Diversification aims to reduce the extent to which your overall portfolio depends on the performance of a particular investment, market or sector.
For example, if a portfolio is heavily concentrated in one company and that company experiences a significant decline, the impact on the overall portfolio could be substantial.
If investments are spread across different companies, sectors, markets and asset classes, the performance of the portfolio is less dependent on any single investment.
Of course, diversification cannot prevent a portfolio from falling in value. During broad market downturns, many investments may decline at the same time. It is one component of managing investment risk, rather than a way of avoiding risk altogether.
How can you diversify an investment portfolio?
Diversification can happen at several levels.
Diversifying across asset classes
Different asset classes have different characteristics, levels of risk and potential returns.
Depending on your circumstances and investment strategy, a diversified portfolio may include exposure to asset classes such as:
- Australian shares
- international shares
- fixed interest investments
- cash
- property and property-related investments.
The appropriate mix will depend on factors including your financial objectives, investment timeframe, need for income and tolerance for risk.
Diversifying across industries
Even within one asset class, it can be important to consider where your money is invested.
Australian shares, for example, can provide exposure to industries including financial services, resources, healthcare, technology, consumer goods and property.
Holding investments across different sectors can reduce your reliance on the performance of a single industry.
Diversifying geographically
Australia represents only one part of the global investment market.
International investments can provide exposure to companies, industries and economies that may not be as strongly represented in Australia.
However, international investing can also introduce additional considerations, including currency movements, different economic conditions and geopolitical risks.
Diversifying across individual investments
Holding a large proportion of your portfolio in one company or investment can create concentration risk.
Spreading investments across multiple companies or securities can reduce your reliance on the performance of an individual investment.
This doesn’t mean that simply owning more investments automatically creates a well-diversified portfolio. If those investments have similar underlying holdings or respond to market conditions in similar ways, your portfolio may still be concentrated.
Where do ETFs fit into investment diversification?
Exchange-traded funds, commonly known as ETFs, can provide one way to gain exposure to a range of investments through a single investment.
Rather than purchasing shares in numerous individual companies yourself, an ETF generally holds a collection of underlying investments.
Depending on the ETF, this could provide exposure to:
- a broad Australian share market index
- international share markets
- particular industries or sectors
- bonds or other fixed interest investments
- property
- commodities
- a combination of different asset classes.
This can make ETFs a useful tool when building a diversified portfolio, particularly when an investor wants broad exposure without selecting and managing every individual investment themselves.
However, not every ETF is broadly diversified.
Some ETFs focus on a particular industry, country, investment theme or relatively small group of companies. Others may have significant exposure to a handful of their largest holdings.
That means it’s important to understand what an ETF actually holds, rather than assuming that investing through an ETF automatically means your overall portfolio is diversified.
What is a diversified ETF?
Some ETFs are specifically designed to provide diversification across multiple asset classes within a single investment.
Rather than investing only in Australian shares or international shares, for example, a diversified ETF may combine several types of investments within the one fund.
The investment manager generally maintains the portfolio according to a predetermined asset allocation.
For some investors, this can provide a relatively simple way to access a diversified mix of investments.
However, simplicity doesn’t necessarily mean an investment is suitable for everyone.
Different diversified ETFs can have very different allocations to growth and defensive assets, levels of risk, investment objectives, fees and underlying holdings.
Before investing, it is important to understand how the fund is structured and whether its investment approach is appropriate for your circumstances.
Can you have too many ETFs?
Owning several ETFs doesn’t necessarily mean your portfolio is more diversified.
Different ETFs can hold many of the same underlying companies. For example, two funds tracking similar Australian or international share market indices may have considerable overlap.
This can result in an investor unintentionally increasing their exposure to certain companies, industries or markets.
When considering diversification, it can therefore be useful to look beyond the number of investments you hold and consider what you actually own across your entire portfolio.
That includes investments held outside your personal portfolio, such as your superannuation, which may already provide exposure to a broad range of asset classes and markets.
Diversification should reflect your goals
There is no single investment mix that is appropriate for everyone.
The way your portfolio is diversified should reflect factors such as:
- your financial goals
- your investment timeframe
- your current financial position
- your need for income or capital growth
- your tolerance and capacity for investment risk
- other investments and assets you already hold
- when you may need to access your money.
Someone investing for a goal several decades away may have very different needs from someone preparing to retire or planning to access their investments within the next few years.
That is why diversification is about more than spreading money across as many investments as possible. The aim is to build an investment mix that works together within your broader financial strategy.
Does diversification remove investment risk?
No investment strategy can eliminate risk.
Even a highly diversified portfolio can fall in value, particularly during periods when financial markets broadly decline.
Diversification is intended to help manage certain risks, particularly the risk associated with having too much of your portfolio exposed to one investment, sector, asset class or market.
There may also be a trade-off. If one investment performs particularly strongly, a diversified investor may not experience the same return as someone who had concentrated more heavily in that investment.
Of course, the reverse can also be true when a concentrated investment performs poorly.
Diversification is therefore less about predicting the next top-performing investment and more about considering how different investments can work together within an overall strategy.
When should you review your investment diversification?
Your investment portfolio may need to change as your circumstances change.
It can be worth reviewing your investment strategy following events such as:
- a significant change in income or financial position
- buying or selling a business
- receiving an inheritance
- approaching retirement
- changes to your financial goals
- changes to your investment timeframe
- changes to your tolerance or capacity for risk.
Your portfolio can also change without you actively buying or selling anything.
If one investment or asset class performs particularly strongly, for example, it may grow to represent a larger proportion of your portfolio than originally intended. This can change your overall level of diversification and risk.
Periodic reviews can help you understand whether your investment mix continues to reflect your circumstances and objectives.
Building a diversified investment strategy
Diversification is an important consideration when building a long-term investment strategy, but there is more to it than simply owning a large number of investments.
Understanding how your investments are spread across asset classes, industries, markets and individual holdings can give you a clearer picture of where your portfolio may be concentrated and how much investment risk you are taking.
ETFs can provide one way to achieve broader investment exposure, but they still need to be considered as part of your overall portfolio and financial circumstances.
If you’re unsure whether your current investments are appropriately diversified, a financial adviser can help you review your portfolio, understand your existing exposure and consider an investment strategy aligned with your goals.
Talk to LBW about your investment strategy
Our Geelong financial advisers work with clients to understand their financial position, goals and investment preferences before considering strategies appropriate to their individual circumstances.
If you’d like to review your current investment portfolio or discuss your longer-term wealth strategy, contact the LBW Wealth team on (03) 5221 6111 or visit https://lbwca.com.au/.
This blog provides general educational information only. The content does not take into account your personal objectives, financial situation or needs. You should consider taking financial advice tailored to your personal circumstances. LBW Business + Wealth Advisors is an Authorised Representative of LBW Wealth Pty Ltd ABN 56 652 382 128 AFSL 534569. Please see our website www.lbwca.com.au or call 03 5221 6111 for more information on our available services.