Reduce risk with a well diversified investment portfolio

Reduce risk with a well diversified investment portfolio

Volatility is the word on many economists’ lips in 2019 as Australian and Global outlooks on stocks, property and banking take a more unclear path. Financial advisers are being asked more than ever by clients and investors as to the timing of when possible downturns will occur and how best to protect themselves against possible downturns in a number of different asset classes. While the forecasts are notoriously unreliable and the timing of downturn events nearly impossible to pick, one risk management technique has the ability to increase returns over different cycles and help offer a buffer against any possible losses.

Ideally, well managed diversification lowers the risk of a portfolio suffering large or total losses while still enabling returns high enough to achieve an investor's financial goals. For instance, a portfolio consisting of just one stock or asset class is far too risky in any macro-economic environment. No matter how confident an investor’s belief for that stock may be, a variety of different factors could derail the investment, causing total losses and a catastrophic end to an investment portfolio.

While there is no silver bullet strategy to guarantee massive gains, or protect against losses, portfolio diversification has been shown to decrease the risk of large losses, and has been studied and shown to be up to 93% of the reason an investment strategy profits.

Set your investment goals

Just like any other aspect of your finances or important aspect of your life, having a plan and goals is the key to success. Investing is all about putting your money to work for you in a range of areas in order to achieve your personal goals. You may have several goals, spread over a vast timeframe, depending on your age and position in your financial journey. Setting a timeframe for each goal will help you work out how much investment risk you can afford to take. Take the time to sit down with your financial adviser to write down some goals and they will be able to help construct a more clear timeline and purpose for you vision.

Balance the risk tolerance vs time scale of your goals

Investing is about balancing the risk vs. Reward of your strategies in line with the time scale of your goals. For example, if you are closer to retirement you are more likely to be thinking of investments that are going to offer stability leading up to your retirement. Whereas a younger person with different goals may be more inclined to undertake more risk in their strategy. If you go too risky you run the risk of losing capital, go too risk averse and your strategy may be too slow to reach your goals. Diversification protects against exactly this. You will be able to take a number of different strategies designed to complement each other’s cycle, making the most of safer strategies along with riskier, high profit investments.

What are some examples of a well diversified portfolio?

According to the latest ASX investor study, up to 75% of share holders hold only Australian shares. This is not overly surprising considering Australia’s share performance over the last number of years, but by focusing solely on Australian shares you could be missing out on other opportunities, and increasing your chances of suffering a larger loss. Broadly speaking, there are three ways to broaden an investment strategy, by investing:

• Across Asset Classes

This is the most common diversification strategy employed by well-rounded investors. This method involves including a range of differing asset classes in your portfolio such as, property, shares and cash. Investing across asset classes is usually the best way to avoid a sudden extreme downturn in one area, by hedging your investments to another strong asset class. Historically, shares provide a greater return than cash, but for those seeking more stable long term returns, cash could be added to ensure a buffer.

• Within an asset class

Secondly is diversifying your investment portfolio by investing in a number of similar assets in the same class. Investment in Australian shares is the most common example, where investors will purchase shares in companies operating in different industries such as biotechnology, banking, mining and retail. It is also becoming more common for personal property investors to add commercial property to their portfolio to open themselves up to different profit and boom cycles experienced by commercial businesses.

• Internationally

It is becoming more common for Australians to invest in stocks listed in other countries. This allows investors to take advantage of high performing international businesses, and businesses that offer new and improved products that may not even be available in Australia yet. It also helps to add a buffer zone to any possible localised economic downturns or recessions.

Ultimately, if you are an investor, or looking to diversify your investment portfolio, your first stop should always be your financial adviser. Portfolio diversification is no magic bullet to becoming the next Warren Buffett, but it does offer fortification against volatile economic movements. If your portfolio needs a tune up, or you are looking to maximise your wealth through investing, portfolio diversification is one of the most well studied and effective strategies to help you sleep better at night knowing you are prepared.