What diversification is

Diversification means holding a mix of asset classes such as domestic and international stocks, cash, fixed income and property. These asset classes have different characteristics, have different expected returns and carry different and varying levels of risk. 

Having a mix of assets in your portfolio avoids concentrating too much of your money in one asset. In short, diversification potentially reduces risk.

Diversification is about reducing risk in your portfolio to weather inevitably shaky markets. We’ve been experiencing our fair share of volatility and uncertainty recently. Morningstar’s analysis showed that across sharp market swings - tariffs, geopolitical turbulence - diversified, balanced portfolios ‘came out of the first quarter of 2025 with barely a scratch.’

Diversification is ultimately about protecting the path toward one's investment goals rather than following a textbook definition of spreading investments widely. This may assist investors in becoming comfortable with volatility or fluctuations in the market. The thinking being: "It doesn’t worry me if markets swing in the short term, so I don’t use diversification as a tool to smooth out returns". 

What may matter to investors is avoiding risks that could cause a permanent setback, like being too concentrated in one company or asset class. An investor wouldn't want a single company or position to permanently set back their portfolio.  If one part of the economy struggles, investors would not want their entire portfolio tied up in it, so they may look at sector concentration.

For some investors the goal is to build enough wealth over the long term to reach financial independence. Diversification may help to manage the risks that could derail that outcome. That’s also why people keep an emergency fund, so as to avoid being forced to sell investments at the wrong time to cover unexpected expenses. 
 

How to diversify across and within asset classes

In terms of asset classes, the traditional way to diversify has been between stocks, bonds and cash. You may have heard of the 60/40 portfolio – that means 60% shares, 40% bonds. These have been the traditional asset classes that are used for diversification because they perform differently to each other.  

Although there have been a few exceptions to the rule, in Morningstar's opinion, government bonds may be a simple diversifier for equity exposure. So, too, cash. 

Importantly, both of these assets may be accessed relatively inexpensively by investors. Your job as an investor is to balance the risk and return of these asset classes with what your portfolio is trying to achieve.

You’re also able to diversify within an asset class. This is particularly important for Australian investors. We see that our local market is particularly concentrated in two sectors – mining and financial services. With that, investors can face something called concentration risk – this is when an investor's portfolio is not diversified enough. Investing in the Australian market may naturally increase your concentration risk.  

Take a hypothetical example, an individual who works in the financial services sector and lives in Australia where the overall prosperity relies heavily on the financial services sector. In considering their own investment goals and financial situation, they may invest in the Australian sharemarket that is concentrated in the financial services sector. 

We’ve all seen the pictures of the Wall Street bankers walking out of their offices carrying a box of their belongings at the start of the Global Financial Crisis (GFC). Referring to the above hypothetical, if there’s a significant event that impacts the success of the financial services market, the individual may be concerned they could lose their job and their investments could tank which could impact the trajectory of the rest of their life. For this investor, ensuring they are not overly concentrated in the financial services sector will lessen the impact of significant events like this. It makes these events recoverable. 

Can you be too diversified?

The short answer is yes. This would involve adding asset classes that don’t reduce risk in your portfolio based on your goals, or that duplicate exposures that you already have in your portfolio. As investors, we’re prone to do this. We don’t like sitting on our hands and doing nothing. More portfolio holdings can feel like we’re doing the hard work for the outcomes we want to achieve.

A Morningstar study showed that we tend to naively diversify. This is a process where we spread our portfolio across many options without any meaningful distinction, often increasing fees without improving the results. 

In the study, investors were presented with three Exchange Traded Funds (ETFs) with different names, but similar exposure. About 86% of investors chose to invest across all options, paying four times more in fees that harmed their portfolio returns. 

To avoid this, ensure you know the underlying holdings that are contained in ETFs you hold. For direct equities, ensure that your holdings aren’t concentrated in the same sectors, geographies or industries.
 

How Dividend Reinvestment Plans fit in with diversification.

When you invest in shares, some will pay you dividends. Dividend Reinvestment Plans (DRPs in Australia and New Zealand) automatically reinvest these dividends back into the same company.

There are a few pros and cons for investors to weigh up with DRPs:

Source: Morningstar

Let’s focus in on that point about concentration. Over the years, DRPs in Australia have sometimes been accused of hurting the diversification of your portfolio. 

Ultimately, though, if you don’t take part in reinvestment strategies, you may miss a chance to compound your returns. 

If you are an investor who is still early on in their journey and making additional investments into your portfolio, you may have the ability to build other positions to diversify. 

If you are later in your investment journey, drawing down on your portfolio, it may be a different situation. 

One strategy to consider is turning off DRPs to redirect the dividends into cash that you can withdraw. 

All decisions have to be made while considering your portfolio on a holistic basis. Meaning, the decision to turn off DRP on one share must be done considering your goals and other positions in your portfolio.
 

Conclusion

Diversification is a balancing act of ensuring you are not over-diversifying or having too much concentration. There’s no right formula or right amount of assets. Base your decisions on the amount of risk you need to take in your portfolio. This is the return that you need to earn to achieve the goals of your investment portfolio.

You don’t need to hold every asset class under the sun to meet some industry definition of diversification. When you do diversify, be intentional about the holdings. Ensure they are still working towards the goals of your portfolio, suit your time horizon and are cost efficient.