Understanding Diversification

Diversification is a key investment principle used to manage some investment risk within a portfolio. It is often described as “Don’t put all your eggs in one basket”.

To diversify an investment portfolio means to invest in a variety of assets and investments that perform differently to each other over time. It is often described as “don’t put all your eggs in one basket”.

You can diversify your portfolio in different ways. Examples of diversification include investing:

• Across a range of asset classes including ‘growth assets” like shares and property and ‘defensive’ assets like fixed interest (bonds) and cash.

• Across different countries such as Australian and international assets.

• Across different securities that provide you access to a range of companies and sectors

THE VALUE OF DIVERSIFICATION

Diversification allows you to participate in the growth and performance of financial markets while reducing risk in your portfolio by moderating the ups and downs in returns over time.  This means that you avoid taking big bets in one asset class and/or a few investments that may adversely affect your returns if it underperforms.

Diversification avoids having your investment fortunes tied to the performance of a small number of securities or assets.  It also allows you to have an exposure to a spread of assets and securities including both ‘growth’ and ‘defensive’ assets.

Diversification provides a greater chance that your portfolio will experience smoother returns over time, particularly over shorter periods. 

The key to diversification is to invest in assets that have different ups and downs in their returns from each other. History has shown that no one asset class has consistently out-performed year after year.

EFFECTIVENESS OF DIVERSIFICATION

Diversification can reduce the risk in your portfolio but it will not eliminate the risks.

Your portfolio is still likely to experience ups and downs in returns over time but with a lower level of variability. Your portfolio may have exposure to specific investments that perform poorly at times and you are unlikely to avoid investing in poor performing investments.  When reviewing the effectiveness of diversification, you should consider the overall performance of your total portfolio.  

The benefits of diversification will vary over different time periods.  Historically in some periods when the broad financial markets decline, the effectiveness of diversification has reduced.  Diversification should therefore be measured over medium to long term periods.

Any general advice on this page does not take account of your personal objectives, financial situation and needs, and because of that, you should, before acting on the advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. Information contained on this page was correct at the time of posting.