My thoughts

Most people understand the broad idea of diversification: don’t put all your money in one place.

What’s easier to miss is where your risk sits.

Imagine a couple about five years from retirement. They own their home and an investment property. They have shares in the four major Australian banks, an Australian dividend fund and separate super funds.

On paper, that looks well spread.

Look underneath, though, and much of their financial position depends on Australian property, banks, interest rates and the local economy.

They own several investments across several accounts. But many of those investments respond to the same events. In this case, what’s happening in Australia.

That’s the difference between looking diversified and being diversified.

Diversification isn’t about how many investments you own. It’s about understanding how much of the same risk you own.

What $100,000 can teach us

One way to see diversification at work is to compare what happens to the same amount of money in different investments.

Imagine investing $100,000 in each of the following:

• Australian shares
• International shares
• Bonds
• A diversified mix of all three

Track them over the same period and you’ll see more than four different ending balances. You’ll see four different experiences along the way.

Australian and international shares may provide stronger growth over some periods, but their values can move further up and down along the way. Bonds may produce a lower return during a strong share market but can bring income and reduce some of the movement across the portfolio.

A diversified mix won’t finish first every year. That isn’t its job.

Its job is to reduce how much your financial future depends on one asset class producing the result you need at the exact time you need it. Not timing the market.

The final return matters, of course. But so does the path you take to get there.

That path becomes important if you need to withdraw money during a market fall, or if a sharp drop makes you uncomfortable enough to sell.

Giving your money more than one way to work

In simple terms, diversification gives your money more than one way to grow, produce income and support you.

You can spread your investments across:

• Shares, bonds, cash and property
• Different companies and industries
• Australian and international markets
• Different currencies
• Several sources of income

The right mix will look different for each person.

Someone building wealth in their forties may invest differently from someone who plans to retire next year. A business owner whose income already depends on the Australian economy may need a different mix from an employee with secure income and no property investments.

Each part of the portfolio should have a reason for being there.

Shares may provide long-term growth. Bonds may provide income and help reduce some of the movement in a portfolio. Cash gives you access to money without forcing you to sell a long-term investment. Property may provide income and growth, but it takes time and money to sell.

These assets won’t behave the same way in every set of market conditions.

ASIC’s Moneysmart guide to diversification explains that spreading money across asset types, sectors and countries can reduce a portfolio’s overall volatility because different investments tend to perform well at different times.

Diversification can’t stop a portfolio from falling. During a large market shock, several types of investments can decline at once.

It can, however, reduce the influence that one company, industry, country or economic event has over your whole position.

So, how diversified are you?

A good place to start is by looking at your full financial position, not each investment on its own.

That includes your super, shares, cash, property, business and income. Then look at what sits underneath them.

Are the same companies appearing in several funds? Does much of your wealth depend on Australian property or the local economy? Could one event affect several parts of your position at once?

It’s important to check in that you have an investment mix that suits your goals, gives you access to money when you need it and doesn’t leave too much riding on one result.

If you’re unsure where your risks sit, we can review your full financial position and help you understand whether each investment is doing the job you need it to do.