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Essential steps to diversified success

Photo of John Nunan By John Nunan

min read

Diversification starts with personal objectives and timeframes.

One of the key principles of good investing is diversification – not putting all your eggs in one basket. Spreading investments across different assets helps to smooth out overall returns while ensuring you are not overexposed to any single investment or asset class.

More than just buying a few managed funds or shares, constructing a diversified portfolio is a personal process that takes considers your objectives, current investments and desired level of ongoing involvement.

Know what you are trying to achieve before setting out to construct a diversified portfolio. For example, are you building a portfolio for your retirement in 30 years or to fund your children’s private schooling in five years?

Decide your timeframe, what sort of return you are chasing and the degree of certainty you require. ASIC’s Moneysmart Retirement Planner is a useful tool when building a retirement portfolio as you can see how your potential income, time to retirement and level of risk will affect the projected final balance.

If you want to earn, say, 8 per cent annually to achieve your financial goals, it is important to understand how well this aggressive strategy fits your personal psychology. If you can tolerate a fair amount of market volatility, you are likely to be reasonably comfortable.

However, if a drop in asset prices is likely to leave you nervously eyeing your portfolio, and perhaps selling, you will need to tread a more conservative path and sacrifice some potential return.

Return objectives and time horizons help determine the types of asset classes you invest in, because over shorter time periods the returns from growth assets (such as shares and property) are far less reliable.

A portfolio to fund private school fees five years from now is best built with a lower-return objective, and more certainty, in mind. In this case, an asset allocation heavily weighted to cash and fixed interest with perhaps a small weighting to shares, could be the way to go (see example in Chart 1).

Chart of asset allocation 5 years

Alternatively, a portfolio targeting a return of 8 per cent a year over 30 years would need to be invested in higher-risk assets such as shares (Australian and international), property and infrastructure (see example in Chart 2).

Chart of 30 year asset allocation

 

Asset allocation “experts” make it sound scientific, and complicated, but it is important to make sensible investment decisions across different asset classes, rather than worrying if 70 or 75 per cent is the “correct” allocation to shares.

Ensure that the success of the investments and asset classes invested in is driven by a variety of factors, reducing the overall risk in the portfolio and increasing the likelihood that good investing will ultimately be rewarded.

Build a portfolio around what you already have

It is rare to start investing with a clean sheet of paper. You are likely to already have some investments, you may own or be buying a house, and probably have a job. You need to build a diversified portfolio around what is already in place.

If you only own stocks in the S&P/ASX 20, you should be working out how to get exposure to international shares, small caps and other asset classes as a priority.

Similarly, if you work within the banking sector and your income – an often unrecognised part of a portfolio – is linked to its success, invest less (or none) in the Australian banking sector; you already have enough at risk there.

Honestly assess how willing you are to allocate sufficient time to do it properly. Normally the time you have available, your skill set and portfolio balance will determine if you invest directly in shares, bonds and property, or take a managed funds approach.

Even if investing is your passion, it is still important to be realistic. Few people have both the time and experience to cover the entire spectrum of investment opportunities, and trying to do it all yourself is fraught with danger.

A specialist fund manager, such as Platinum Asset Management, has 28 investment professionals. Can you honestly replicate what they are doing yourself? A $50,000 investment in Platinum International Fund, for example, sees them travelling the world, meeting companies and buying international shares for you for around $750 fees per annum – a fraction of what it would cost you to do.

Perhaps you want to manage the Australian large-cap part of your portfolio and use managed funds to invest in other asset classes. Alternatively, you might decide to use managed funds for your entire portfolio. There is no one right solution; it depends more on your skill set, time commitment and portfolio balance.

Building a diversified portfolio is more than just owning 10 Australian and international shares. It is investing across and within each of the key asset classes, owning shares across different countries, sectors, and both large and small companies. In the context of fixed interest, it means owning bonds issued by different governments and companies around the world with varying levels of risk.

The good news is you are spoilt for choice. There are direct shares, managed funds (either directly or through mFund), exchange-traded funds and listed investment companies.

Each option has its pros and cons, but if you favour a managed fund approach, even investing in a few funds – say a fixed-interest fund, two Australian and two international share funds – will see you end up holding quite a diversified portfolio given the number of underlying investments these funds typically own (see example in Table 1). Ideally though, you would aim to add a few more funds – including some property and infrastructure – to this mix.
 

Table of simple portfolio

Take a patient approach to achieving your ultimate diversified portfolio. Immediately selling down your current portfolio to achieve greater diversification may not make sense from an investment or tax perspective, nor the transaction costs incurred. Instead, consider building around your current holdings; that is, deploy any new surplus cash either from savings or sales of other investments, into desired investments.

However, keep in mind that valuations matter. If some of the investments you own look over-valued and there has been a significant sell-off within a sector or individual asset class you would like exposure to, it may make sense to trade.

Once established, maintaining the right level of diversification is crucial and this is best done by rebalancing when necessary, by investing new cash into the underweight asset classes or partially selling down investments that are overweight.

Remember, there is no definitive right answer to building a diversified portfolio no matter how precise some financial models might look. Building your own portfolio is a personal matter and ultimately depends on what you are trying to achieve, and on your current portfolio (even if the only current investment is your job).

About the author

John Nunan is a founder of Eviser, an online financial advice service helping you take control of your super through investment advice, model portfolios and expert Q&A.

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The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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