Investing basics: your guide to diversification
More than 60 per cent of Aussie investors only own local stocks - but adding overseas equities and other asset classes could protect your portfolio from losses.
Volatility has returned to global equity markets and along with it, the prophets of doom. Billionaire US money manager George Soros warned earlier this year that “we may be heading for another major financial crisis.”
Fidelity head of investment solutions David Buckle is more exacting, predicting Australian investors have 18 months to prepare for the next US recession.
These forecasts would rattle anyone whose wealth shrivelled in the global downturn, particularly anyone on the verge of retirement who can’t afford to see their savings implode.
Timing the market is near impossible, even the professionals get it wrong. But history tells us it’ll happen sooner or later. But there are some simple steps every investor can take to help protect their portfolio from the ups and downs of financial markets. The aim here is to prepare, not predict.
How to protect your portfolio
With any reward there's always some element of risk. And the greater the potential reward, the greater the potential risk.
Readers of this series will remember Equity Mates' Alec Renehan's big and only bet on law firm Slater + Gordon when first starting out as an investor – on which he's since lost almost all his investment. A great performing growth stock could see your investment flourish, but if the company goes bankrupt so too will your investment.
So as investors, how can we protect ourselves? The phrase 'don't put all your eggs in one basket' comes to mind. Instead of selecting one or two major Australian bank stocks and crossing your fingers, a diversified portfolio of investments helps you manage the risk/reward trade off by spreading risk.
No single asset class consistently outperforms the others year on year. Choose the right range of investments and you will find some investments peak as others go down, smoothing your portfolio returns and protecting your wealth from volatility.
Source: Vanguard Investments Australia
Why do Aussie investors need to diversify?
Australians are peppered with messages about the need to diversify, but historically they have favoured home bias. Of the 11 million Australians holding investments outside of their superannuation fund, the majority tend to place all their eggs in one – local – basket.
Up to 75 per cent of share owners hold only Australian shares, according to the latest ASX Australian Investor Study. Forty per cent of those investors admit they don’t have diversified portfolios, and among Morningstar Premium subscribers, 60 per cent say they hold no overseas investments.
And it's not all that surprising. In 2016, Australia’s S&P/ASX 200 outperformed other developed equity markets, and investors chase good performance. Additionally, the imputation credits earned by holding shares in locally listed companies are an alluring tax incentive for Australian investors.
Global uncertainty, dominated by Britain’s decision to leave the European Union, the election of Donald Trump in the US and the subsequent trade war with China, and lingering investor scepticism in the wake of the 2008 global financial crisis, also contribute to investor uncertainty.
A greater familiarity with local versus foreign companies also influences the decision of many investors to stick with domestic equities.
But if you're only focusing on Australian equities you could be missing out. The Australian stock market is particularly concentrated, with the financial and mining sectors accounting for about 60 per cent of the ASX All Ordinaries Index. In market capitalisation terms, Australia only makes up 2 per cent of the total global stock market.
The Australian market lacks any significant tech stocks, which have been a major driver of overseas markets – businesses like Apple, Microsoft, Samsung, Amazon, Alphabet, and Alibaba.
Diversifying your portfolio beyond Australia can offer a much broader range of class-leading businesses.
Three simple ways to diversify your portfolio
Broadly, they are three ways to add diversification to a portfolio, by investing:
- Across asset classes
- Within an asset class
- Internationally
Across asset classes
The first way to diversify is to include a range of asset classes in your portfolio, for instance, shares, property, cash and fixed interest. 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 bigger losses. At times an investment weighted towards stocks can still perform worse than one weighted towards bonds, even over a long period.
Within an asset class
Secondly, you can diversify within an asset class. Within Australian shares, for instance, you may buy shares in companies operating in different industries such as mining, retail, biotechnology and banking.
Across countries
And finally, you can invest in stocks listed in other countries, such as the US, Europe or Asia, thereby curbing your home bias. Diversifying your portfolio beyond Australia can offer a much broader range of class-leading businesses. Restricting investments to Australia closes the door to potentially lucrative opportunities elsewhere.
Morningstar's ETF Model Portfolios
Source: Morningstar Australia
What does a diversified portfolio look like?
Premium subscribers can use Morningstar's Instant X-Ray tool to analyse their current portfolios. You can also build fantasy portfolios, too, to see if your choices are as diverse as you think they are before you take the plunge and buy.
Morningstar.com.au also invites investors to check their current portfolios against the Build a Portfolio tool – which offers investor a template for diversification. The portfolios are based on the time horizon and level of risk an investor wants to take on.
Does diversification have any downsides?
It’s worth mentioning that diversification can come with downsides. By reducing your risk, you may also narrow the scope your returns – or profit maximisation. There also could be a case that by investing broadly, you fail to gain a deep understanding of any particular asset class or equity sector.
Ultimately, regardless of whether markets are going up, down or sideways, diversification fortifies your portfolio. If you’re a beginner investor, start with a diversified portfolio. If your portfolio needs a tune-up, consider trimming similar exposures where you have had gains to add diversification. Over time you’ll achieve better returns, and perhaps more importantly, be able to sleep soundly knowing you’re prepared for whatever the market throws at you.
More in this series
• Investing basics: Check this before investing in LICs and ETFs
• Investing basics: the art and science of valuing stocks – pt.2
• Investing basics: 5 questions to ask before investing in funds
