Investment Diversification Explained
What is diversification?
In its simplest form diversification means not putting all your eggs in the one basket. Its sound simple, right?
The truth is there’s quite a bit to it. Portfolio diversification theory was first established by economist Harry Markowitz in 1952 (he subsequently won a Nobel prize for his work in 1990). Labelled the modern portfolio theory, this set of equations and principles helps investors better understand how to create a diversified portfolio that mitigates against investment volatility and risk as best as possible.
Modern portfolio theory simply says that one of the most effective means of reducing the effect of risk is to diversify your portfolio. This is because no single investment, asset class or investment manager provides the best performance over all time periods. Having a broader range of investments can reduce the risk your portfolio because it is unlikely they will all experience drops in performance at the same time. This is simply because one asset class or manager may perform well to counter the poor performance of another. Even the best investment managers are likely to experience short-term underperformance if market conditions do not suit their investment strategy.
How do you achieve portfolio diversification?
Diversification can be implemented in three distinct ways by investing:
Across asset classes (Cash, Fixed Income, Australian Shares, Overseas Shares, Property etc.)
Asset classes perform differently under different market conditions. By investing across a variety of asset classes you may be able to reduce the volatility of your portfolio return.
Across markets and regions (US, Europe, Asia, Japan, Australia etc.)
Spreading your exposure within each asset class across a wide range of countries, currencies, industries, and companies ensures your investment is not narrowly concentrated or dependent upon the performance of a single area, region, industry or company.
Across investment management styles (Index or Active, Value or Growth, Small Cap etc.)
Different investment management styles tend to excel under different economic and market conditions. By combining a range of investment managers with complementary investment styles you may be able to reduce reliance on any one style within each asset class.
Why more diversification may benefit you over time
Diversification is a genuine way of reducing uncertainty without compromising expected future returns. We advocate remaining invested in a well-diversified portfolio that accesses a range of investment strategies and styles that each perform well in varying market environments.
As a result, elements of our portfolios will perform well even during market uncertainty, which removes the need to engage in risky market timing strategies. We believe this is the most prudent approach to achieve consistent and strong long-term returns.
The portfolio diversification theory established by Markowitz remains a highly effective method of analysis, but it should always be considered one element of a larger investing toolkit rather than a one-size-fits-all solution for all investment needs.
For those who may have additional questions about portfolio diversification, it is best to speak with a financial adviser before actively putting money into investments. Professional financial advice can help you better understand how specific assets may contribute to your portfolio and ensure the best possible return relative to your own tolerance for risk
Asset Class Categories and sub-categories
When considering where to invest, and how to diversify, there are a broad range of investment strategies and styles to choose from as outlined in the table:
