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What is a diversified portfolio and why is it important?

Find out why a diversified portfolio is important to reduce your risk as well as maximise your investments.

When people are new to the world of building wealth via investments, they often have a very simplistic view of how this is achieved. Buy low and sell high, right? In principle, yes — but in practice, it’s not quite that simple.

Experienced, long-term and successful investors typically maintain a range of different investments in various asset classes to maximise their returns and minimise their exposure to risk. But portfolio diversification can seem a bit daunting if you’re new to investing or haven’t considered it previously.

Most Australians will be diversifying their portfolios already through their superannuation, and the good news is, the basic principles are actually pretty straightforward to understand.

Diversification in financial planning is essentially a way to reduce the risk of losses and build a stable portfolio.  You want your portfolio to keep pace with inflation, and ideally make a good return.

Diversification makes this much more likely. Despite what pop culture and the media may depict, it’s relatively rare that people strike it rich after one or two investments.  As with most other areas of life, slow and steady wins the race. Over a long-term period, diversifying allows you to balance your comfort level with your risk appetite more effectively — there’s less on the line to potentially lose in any one area, while the gains can be much more significant, as your net becomes larger and wider.

Creating a diversified portfolio

So how do you create a diversified investment portfolio?  You need to invest in a range of assets and options within each asset class.  Let’s take a closer look at each asset class and explore some of the options within them.

Different asset classes

There are four main types of assets in Australia — cash, fixed interest, property and shares. Each of these different types of assets will perform well at different periods within the life cycle of your ownership of the asset so it’s a good idea for your portfolio to contain a mix of some or all of these asset classes.

  • Cash — Cash is generally considered one of the lower-risk investments, though conversely, it’s also likely to provide lower returns as a result. However, most serious investors will invest at least partially in cash in order to act as a bulwark against other market fluctuations.  Many investors opt to invest in foreign currencies, trading them against one another as values fluctuate in order to make a profit.
  • Fixed Interest — This asset type includes bonds, securities and debentures.  You’re effectively lending money to a corporation or government, which will then pay out a rate of interest on the “loan”. Other payouts are made on the basis of an increase or decrease in value on the underlying asset and as interest rates fluctuate. Fixed interest products can offer better returns than cash, but they do have a slightly higher risk. However, they also tend to be considered more stable than property or shares.
  • Property — Property is often seen as the most reliable type of investment. However, this isn’t always the case, especially if thorough research isn’t done beforehand.  Though the potential for significant gains is certainly present as we’ve seen in recent times, property can be subject to the same fluctuations as any other market.
  • Shares — Shares are often the first thing people think of when considering investments.  There’s considerable potential for growth and profit, but depending on the type of shares you invest in, there’s also an elevated risk of losing it all — this is why a diversified portfolio becomes so important.
Investing within asset classes

Additionally, investors will typically diversify within the above asset classes. For example, a share investor may own shares across a broad range of industries, and include both Australian and international shares to minimise risk and maximise the potential returns.  A property investor may own properties in different geographic locations, or split their property investments across both commercial and residential properties, as the two operate on different cycles.

The intended outcome of having a diversified portfolio is to limit your exposure to risk and enable you to still benefit from your well-performing assets, even if the others are going through a downward period. But before diversifying, it’s worth consulting with a professional financial adviser.  They’ll be able to offer a variety of investment and wealth management services, which can help you make informed decisions around diversifying your investment portfolio and reducing your exposure to risk.

FAQs
What does it mean to have a diversified investment portfolio?

A diversified investment portfolio essentially means that your investments aren’t concentrated solely in one asset class or one option within an asset class.  A well diversified portfolio may contain a mix of cash, fixed interest, property and shares.  Each asset class will also contain diversified options.  For example, shares will be a mix of Australian and international and across a range of businesses and industries. It’s a good way for conservative and more adventurous investors alike to help balance their risk appetite while also maintaining stability in the process.

What does a diversified investment portfolio look like?

A diversified portfolio means that investments aren’t concentrated on a single asset class, or single option within each asset class.  Everyone’s investment portfolio will look different according to their individual circumstances, goals and appetite for risk.

Why should you diversify your portfolio?

Different industries are prone to different peaks and valleys at different times.  Having a diversified portfolio can help ensure that you’re managing your investments as effectively as possible. In practical terms, this means that a diversified portfolio should enable you to reduce your risk while also maximising your investments.

How many stocks should I have in a diversified portfolio?

This will vary from individual to individual.  A diversified share portfolio is generally part of a larger set of diversified investments, which may include assets such as cash, fixed interest and property.  There should then be diversification within the share portfolio itself, with shares from a range of companies and industries, both onshore and offshore.  Accordingly, it’s worth speaking to a professional financial advisor in order to ensure that you’re getting the best possible returns.

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