Why you should diversify your investments

Have you ever heard the term “diversification”? It’s one of those investment terms that appears everywhere, yet it’s often not explained clearly.

Diversification is the process of spreading your investments. This helps you avoid unnecessary risks, and reduces your losses on any one investment.

Don’t put all your eggs in one basket

Imagine you have $10,000 that you want to invest, and you’ve decided to buy some shares. You may be tempted to choose a company that you’re familiar with (or that someone recommended as a hot tip), buy that $10,000 worth of shares, and then sit back and hope for the best.

While it’s common among young investors, this is the epitome of non-diversified investing. Investing all your money in just one place leaves you bearing not just the risk of being an investor in the sharemarket, but also all the risks associated with that one company.

What if the CEO of the that company suddenly resigned, or earnings were lower than expected, or there was an expensive lawsuit, or the industry slumped, or a law changed, or there was a recession — or a hundred other things that could lead to that company’s share price falling? You could lose a significant amount of your investment. It’s not unprecedented for individual companies to lose nearly half their value in just a few days.

Investing is unpredictable, so don’t go “all in” on just one investment. There’s a smarter way.

Diversified investing is less risky

Instead of exposing yourself to just one company, you could spread that $10,000 over hundreds, or perhaps thousands, of different companies, in different industries, and perhaps even located in different countries. Your share portfolio would be now be diversified, with the risk now that of being an investor in the sharemarket.

If that company you had considered investing in was part of a well diversified portfolio, and did experience some misfortune, it would only slightly impact your portfolio. Having an intelligently diversified portfolio means that your financial destiny isn’t dependent on the success just one investment.

Diversification in practice

Just as you shouldn’t just pick one share, you shouldn’t invest in shares unless you have the time and temperament to maintain your holdings through the occasional market dip. Intelligent diversification begins with appropriately allocating your investments across different asset classes. An asset class is a type of investment that has broadly similar risk and return characteristics. The four most common asset classes for individual investors are cash, bonds, property and shares (sometimes referred to as equities).

A diversified portfolio includes a mix of asset classes. Shares and property have higher return and risk expectations, so they’d make up the majority of a growth portfolio. Bonds and cash have lower return and risk expectations, so they’d make up the majority of a conservative portfolio.

Why diversify? Because we can’t predict the future

The key reason that diversification is so important is because we just don’t know what the future holds, and diversification provides some level of protection against being wrong about future expectations. And humans aren’t great at predicting future outcomes, whether in the personal, political or financial realm.

The chart below shows the returns generated by a range of investments over the past eleven calendar years, from the highest returning to the lowest returning for each year.

click to see full size

The above chart looks, for all intents and purposes, like a patchwork quilt. There’s no discernible pattern to past returns. Investments that perform the best in one year can come in dead last the next. It’s part of the reason why you should always remember that past performance is not a reliable indicator of future performance.

In the face of this investment uncertainty, diversification reduces your risk of picking an investment that underperforms.

How does Clover build diversification into portfolios?

Our first step in building diversified portfolios is to select the asset class mix. Clover portfolios are built with uncorrelated asset classes, which when combined together, are likely to achieve superior long-term risk adjusted returns. For example, history has shown that when shares fall, bonds tend to rise.

Clover portfolios are made up of four to six asset classes depending upon the portfolio you are recommended.

Once we have built the ideal asset class mix for our portfolios, the next step is to select the most appropriate ETF for each asset class. We believe that low-cost, passive, and broad asset class based index tracking ETFs are the most suitable approach to building long-term diversified portfolios. Our investment committee selects the most transparent, liquid and low cost ETFs which use a clear methodology to track the return profile of any given asset class.

The end result is that Clover portfolios are diversified over asset classes, geographies, and companies. In fact, a single Clover portfolio can contain investments in up to 5,000 separate companies!

The bottom line

Diversification is one of the key investment strategies that we use at Clover, and one that we’d recommend all investors understand.

Although proper diversification is more difficult to set up than simply picking shares you feel good about, it does increase your expected risk-adjusted returns. Plus, in a volatile or falling market, you can sleep better knowing your portfolio is cushioned from sudden and extreme losses.

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All returns are total returns in AUD

Indices Used:

Australian Shares: S&P/ASX 300 INDEX
International Shares: MSCI WORLD ex AUSTRALIA
International Shares (Hedged): MSCI World Ex Australia Hedged (Net)
Australian Listed Prop: S&P/ASX 300 A-REIT
Emerging Markets: MSCI Emerging Markets
Australian Fixed Income: Bloomberg Composite AusBond Index (0+)
International Fixed Income: Bloomberg Barclays Global-Aggregate Total Return Index
Cash: Bloomberg Ausbond Bank Bill Index