Diversification is a straightforward concept that is commonly misapplied and misunderstood. The goal of building a diversified portfolio is to lower risk without impacting the level of returns. The key question is: What is the risk that you are trying to diversify away from? We think about risk differently than most of the financial industry, who use terms such as “price volatility” and “standard deviation”. Traditional views of diversification are based on the correlation between different assets classes and are focused on creating a portfolio that contains asset classes that show little correlation. In other words, the portfolio contains some asset classes that are supposed to go up when other asset classes go down. That way there is less short-term volatility in the overall account value.

Morningstar uses a simpler and more practical definition. We define risk as losing money that can’t be made back. For investors, that’s the risk of not having enough money in time to retire or having to change your lifestyle so that your savings last throughout retirement. Take some time to think about your own view of risk and how fluctuations in your portfolio would impact your life. If you are investing for the long term and can adequately cover any short-term cash outlays with an emergency fund, then perhaps your definition of risk is the same as ours. The less value that an investor puts on the correlation of returns of different asset classes, the more attention can be paid to building a portfolio of global investments that are trading at attractive prices compared to intrinsic value.

Why diversify?

It is impossible to predict market movements accurately. Attempting to do so is little more than speculation. However, you can reduce the impact of market movements by diversifying your portfolio. A diversified portfolio is spread across several different asset types. Diversifying prevents the value of your portfolio from being dependent on the performance of a single asset type. A fall in the value of one investment may be offset by gains in the value of another.

Ways to diversify

Why diversify across asset classes?

Investing across asset classes can substantially alter your investing experience. Stocks may provide a greater return than bonds over the long run but are also more likely to suffer more significant losses. At times an investment weighted towards stocks can still perform worse than one weighted towards bonds, even over a long period.

Diversification does not eliminate the risk of experience a negative investment outcome but the degree of loss can be reduced.

Mixing stocks and bonds

Why diversify within an asset class?

This represents the classic “don’t put all your eggs in one basket” approach to diversification. If you owned stock in a single company and the company flourished, so would your investment. But if the company went bankrupt, you could lose all of your investment. To reduce your dependence on that single company, you buy stock in four or five other companies, as well. Even if one of your holdings sours, your overall portfolio won't suffer as much. By investing in a fund, you're getting this same protection.

Why diversify internationally?

There are some good reasons why equity investors around the world favour their home market. For example, in Australia, imputation credits earned by holding shares in locally-listed companies are a particularly attractive tax incentive.

On more of a subconscious level, a greater familiarity with local versus foreign companies also influences many people to stick with domestic equities.

However, numerous studies highlight the pitfalls of taking too narrow a view on the assets you're willing to add to your portfolio. Australian Tax Office figures indicate less than 1 per cent of Australian SMSF assets are invested directly overseas.

The Australian stock market is particularly concentrated, with the big four banks plus BHP Billiton (ASX: BHP), Rio Tinto (ASX: RIO), the "big four" banks, Telstra (ASX: TLS), Wesfarmers (ASX: WES), CSL Limited (ASX: CSL) and Woolworths (ASX: WOW) accounting for more than 50 per cent its total capitalisation.

Collectively, the financial and mining sectors account for around 60 per cent of the ASX All Ordinaries Index.

Diversifying your portfolio beyond Australia can offer a much broader range of class-leading businesses--and there are various ways of gaining direct access to international equities. In market capitalisation terms, Australia only makes up 2% of the total global stock market. Restricting investments to Australia leaves a good deal of potential investment opportunities off the table.

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Mark Lamonica is a product manager, Individual Investor, Australia.

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