Investing: How to Use Diversification to Your Advantage
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You’ve probably heard this a lot in investing: you need to diversify.
There’s a good reason that we all say it—diversity is king.
If you look at the most successful economies globally, they’re successful because they’re very diverse and have various ways of earning income for the country. They have manufacturing, high tech, commodities, and others.
When an economy is complex and diverse, it will win. The same goes for companies, and the same goes for your investment portfolio.
Why is diversity king?
Because economies (both world and local) go through different stages.
There are winners and losers during the different stages, and it’s tough to predict who will land where.
As investors, we want to put our money aside and let the money manage itself.
And a good, diversified portfolio has excellent risk when compared to rewards.
A diversified portfolio will have good long-term returns and manage itself well. This has been proven time and time again.
I think of diversity in terms of three factors. The first factor is the one that most investment professionals will talk to you about. That’s asset diversity or balance of stocks and bonds.
How much should be in stocks, and how much should be in bonds?
If you went to a financial advisor, you would be required to fill out a risk profile or risk questionnaire.
This kind of form will ask questions like how would you feel if you lost 20% of your portfolio, or how long before you expect to retire?
Financial advisors use these questions to ascertain if you need a balanced (more conservative) portfolio or a growth (more aggressive) portfolio.
The more conservative you are, the more bonds you’ll have in your portfolio compared with fewer stocks.
The more aggressive and growth-orientated you are, the more stocks you will have in your portfolio.
A lot of people already have this set up passively through super.
Your superannuation drips nicely into a super account, where it’s invested. But I find that many people don’t look too much into their super account—they just rely on the default.
But the standard super account is a balanced portfolio. And someone who would need a balanced portfolio account should be close to retirement. But if you’re in your 20s and have default super, it isn’t making you the money that it can.
The next level of diversity is sectors.
Why should you invest across different sectors?
Here’s where it gets a bit trickier, and people can misunderstand.
People often believe that they have diversity and are risk-managed in their investments but are concentrated in one sector.
If you only invest in financials, you’re not diversified.
Financials do well in a booming economy. During low-interest-rate periods, and a booming house market, the banks do well. But during a downturn, banks do terribly.
And if you’re only invested in banks? Well, you’re set to lose a lot of money.
That’s not diversified. If you’re all in financials, you really need to look at sector diversity. So, to diversify, you may want to look at what stocks do well during a downturn.
During BREXIT, the sterling went down significantly.
But over 50% of the FTSE 100 (the British/UK stock market index) rely on their income from overseas. The companies that earn their income outside of the UK and in non-sterling and non-GBT did very well, and so did the people who invested in them.
Different sectors do well in different stages of an economic cycle.
The third way of diversifying is international diversification.
Investopedia has a list of the 11 recognised sectors you can read here.
Should all your investments be in Australia?
Australians in particular (compared with other countries) are very concentrated in their own stocks. But if all your investments are in Australia, and the Australian economy does poorly, you will suffer. Your risk isn’t diversified at all.
You want to look at other countries. So, if Australia suffers and we have a significant commodity downturn, but the US economy might be doing great, and you have investments in the US, you may come out on top.
International diversity is very underlooked and certainly something I take advantage of.
So, to use diversification to your advantage, remember…
- A diverse portfolio helps manage risk—the more diversity, the safer you will be through the highs and lows of the economic cycle.
- For a high-growth strategy, invest more in stocks; for a balanced approach, invest more in bonds—if you are near retirement, you should have a more balanced portfolio.
- Don’t invest in only one broad sector—
- Invest in international markets—investing only in the country that you live and work in is very risky; mitigate your risk by investing in other markets as well.
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This information has been provided as general advice. We have not considered your financial circumstances, needs or objectives. You should consider the appropriateness of the advice. You should obtain and consider the relevant Product Disclosure Statement (PDS) and seek the assistance of an authorised financial adviser before making any decision regarding any products or strategies mentioned in this communication.
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An ex-Wall Street advisor who worked with major players in the global financial industry for over 30 years, Paul’s mission is to help regular people reclaim their wealth and financial security.
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