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Diversification fundamentals in portfolio construction

Written and accurate as at: Jun 10, 2017 Current Stats & Facts

Diversification, or spreading your risk, is a key risk management strategy used when constructing a portfolio whether inside or outside of superannuation.

It’s the strategy commonly referred to as “not putting all your eggs in one basket”.

The premise behind diversification is that no one asset or type of asset provides the best performance over all time periods – they tend to rise and fall at different times depending on economic, political and market factors.

 

 

Methods of diversification
Diversification may often be achieved by:

1. Spreading your funds across a variety of asset classes. Cash, fixed interest, property and shares all have particular risk and return characteristics and typically tend to perform differently under certain market conditions. By investing across asset classes, you may be able to reduce the volatility of your overall portfolio returns

An example of the performance of asset classes over the last 5 years is illustrated in the table below.

 

Asset Class Total Returns

(as of 28 April 2017)*

 
Annualised Returns %^

 Asset Classes  1 Year  3 Years 5 Years

 Australian Shares

 (ALL ORDINARIES)

16.65 7.38 10.58

 International Shares

 (S&P GLOBAL BMI)

15.97 5.98 9.72

 US Shares

 (S&P 500)

17.92 10.47 13.68

 Australian Fixed Interest

 (S&P/ASX AUSTRALIAN FIXED INTEREST INDEX)

2.56 5.19 5.05

 Australian Listed Property

 (S&P/ASX 300 A-REIT)

6.11 15.61 16.21

 Cash

 (S&P/ASX BANK BILL INDEX)

1.88 2.27 2.60

*S&P Dow Jones Indices.

^Past performance is not a reliable indicator of future performance.

 

2. Spreading your funds within each asset class across a wide range of industries and geographical regions. By doing this, you are making sure that your portfolio is not concentrated heavily in one place, which may help reduce the impact of a downturn in a particular market or region.

An example of the performance of different industry sectors within a specific asset class over the last 5 years is illustrated in the table below.

 

S&P/ASX 200 Sector Total Returns

(as of 28 April 2017)*

 

Annualised Returns %^

 Australian Share Asset Sectors                     1 Year  3 Years 5 Years
 A-REIT 5.82 15.54 16.24
 Consumer Discretionary 16.67 1.88 15.19
 Consumer Staples 13.53 10.10 8.65
 Energy 11.24 -10.28 -5.21
 Financials 26.22 10.25 16.52
 Financials Ex A-REIT 26.56 8.20 15.83
 Health Care 18.61 20.04 23.68
 Industrials 10.85 14.77 12.12
 Information Technology 14.01 6.20 13.22
 Materials 21.54 2.34 1.05
 Resources 19.85 -4.06 -3.27
 Telecommunications Services -20.29 -1.45 10.08
 Utilities 32.96 21.51 18.97
 ASX 200 17.77 7.27 11.01

*S&P Dow Jones Indices.
^Past performance is not a reliable indicator of future performance.

 

It’s important to note that diversification will not ensure against loss within your portfolio, it's about managing the risk/reward trade off by selecting a mix of quality investments to help you achieve more consistent returns over time.

 

Investment Mix
The overall exposure that you have to different asset classes, markets and regions, as well as how diversification will be applied, will depend on numerous factors, such as your risk tolerance, financial situation, and financial goals and objectives.

One possible way to look at your investment mix is the timeframe in which you would like to be invested and what you would like to achieve from your portfolio in that given period of time. For example, if you have a:

  • Long-term timeframe and wish to accumulate wealth – your investment mix may have a larger allocation towards growth assets, such as property and shares. These asset classes typically experience more volatility in the short to medium-term; however, they have a greater potential for capital growth in the long-term when compared to other asset classes, such as cash and fixed interest.
  • Short-term timeframe and/or desire to generate income – your investment mix may have a larger allocation towards cash and fixed interest. These asset classes generally experience less volatility and are more focused on capital preservation (rather than capital growth), and income generation when compared to other asset classes, such as property and shares.

An investment mix is not ‘set and forget’. Different types of assets may have differing returns from year to year. Over time, if left unchecked, this may result in the investment mix moving away from the original allocation set. Consequently, regular reviews of your portfolio are important – in some instances, rebalancing your investment mix may be necessary to make sure your portfolio continues to meet your risk tolerance, financial situation, and financial goals and objectives.

 

Moving forward
If you would like to know more about diversification and how it relates to your portfolios, please don’t hesitate to get in contact with us.

Also, take the time to check out the section on diversification within our Investments Module.

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