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How important is diversification?

Diversification is a risk management strategy that involves investing across or within different asset classes to minimise the ups and downs of financial markets. In other words, diversification is about not having all your eggs in one basket.

Although having a diversified portfolio won’t eliminate risk, a well-thought out diversification strategy can help keep to reduce risk and help with gaining more consistent returns over the long run.

What are asset classes?

Investments are often divided into asset classes - categories of investments that display similar characteristics and market behaviours. Generally speaking there are four broad asset classes– cash, fixed interest, property and shares.

How does diversification work?

Diversification works by spreading investments across and within different asset classes. Because asset classes have their own unique economic cycles, when one class is making stronger returns, another may not be performing as well. By spreading your investments across and within different asset classes you’ll be in a better position to offset the volatility of individual investments.

Tailoring diversifying to suit your needs

Aside from dividing your investments across different asset classes, there are a number of other factors to take into account as well; in particular what life stage you’re at (such as early in your career or close to retirement), what your financial goals are and what your attitude to risk is.

For example, you might be nearing retirement and looking for a range of investments that will preserve your capital while also providing you with an income. If you’re earlier in your career, though, chances are you’re not as focused on earning an income stream from your investments, rather you’re interested in capital growth.

You may be more comfortable when you’re younger with taking on a higher level of risk as you’ll usually have more time to ride out periods when a particular asset class may not be performing as well (it could also offer a buying opportunity).

Strategies for diversifying

There are several different ways to create a diversified portfolio. These include:

  • Spreading your investments across the main asset classes by assigning a portion of your portfolio to shares, property, fixed interest and cash
  • Diversify within asset classes, such as investing in shares within different sectors. This would mean ensuring you have a well-balanced share portfolio representing the major sectors such as mining, materials, financials and consumer discretionary.
  • Diversify with a managed investment. This could be a cost-effective means of gaining exposure to a range of different sectors, markets and asset classes within the one investment. You could consider investing into an unlisted managed fund or buying an ETF on the Australian share market.
  • Invest in local and international markets. Rather than just having money invested in Australian markets, you could look at overseas markets as well. This is because different markets can operate on their own economic cycles as well. A managed fund or investment could be a cost-effective way to gain exposure to international markets.
  • Invest at regular intervals as this can help iron out volatility in share prices and other investments. This is because the market prices tend to fluctuate over time, so making regular investments rather than all at once lessens the likelihood of only adding to your portfolio when prices are high.

Reviewing your portfolio … or opting for an investment that’ll do it for you

It’s important to review your investment portfolio regularly to make sure the asset allocation is still meeting your investment objectives.

You should also consider speaking with a financial adviser.

Find out more about managed investments.

Things you should know

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