Australia Markets close in 36 mins

How to diversify your portfolio

How to diversify a portfolio. Source: Getty Images

It’s one of the first lessons in investing – diversify.

The steady days of investing are over. We started 2018 with a burst of volatility, rode the waves of the Trump-China tariff dispute and finished the first 10 months of the year with Red October on the stock market.

To make matters worse, we could be hit with a recession as soon as 2019, experts are warning.

It’s commonly accepted that one of the best ways to ride out volatility is through holding a well-diversified portfolio.

The problem is, two thirds of self-managed super fund (SMSF) investors think they’re diversified if they are investing in 20 shares.

According to the SMSF Association, this is far too low.

The same SMSF Association data showed 47 per cent of investors have most of their portfolio in one asset class. This is usually shares or property.

Earlier this year, investment manager Vanguard raised the same alarm, findings that 84 per cent of SMSF investors thought 30 Australian shares represented diversification.

“47 per cent of investors have most of their portfolio in one asset class.”

“Instead it is harbouring high equity concentration risk and home country bias, in addition to very low levels of exposure to international shares and bonds,” said the head of corporate affairs, Robin Bowerman.

Okay, I get it. What is diversification?

Diversification helps investors ride out the highs and lows of financial markets, according to the Australian Securities and Investments Commission (ASIC).

It’s important to remember that diversification doesn’t guarantee gains or protections against any losses – it’s a mechanism to smooth out returns during volatile periods while making the most of compound interest over time.

Essentially, diversification means spreading your investments across a range of assets, markets and sectors to ensure that if one tanks, your entire portfolio isn’t lost.

However, not everyone loves the approach.

“Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing,” investment guru and Berkshire Hathaway CEO Warren Buffett said.

It’s a sentiment backed up by his vice chairman, Charlie Munger.

“Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing.”

“The academics have done a terrible disservice to intelligent investors by glorifying the idea of diversification. Because I just think the whole concept is literally almost insane. It emphasises feeling good about not having your investment results depart very much from average investment results. “

Fund managers at Fidelity take a different approach. In an investment insight, Fidelity said that while diversification isn’t about boosting performance, history has shown that diversification can deliver long-term value.

How do I diversify?

“An ideal investment portfolio will include some investments that have a higher risk and reward (growth assets) and some investments with a lower risk (defensive assets) and reward,” ASIC says.

“The proportion of each type of asset will depend on your investment time frame and your personal risk tolerance.”

The major asset classes include cash, fixed interest, property, shares and bonds.

You should avoid putting your entire portfolio into any one asset class. For example, if you already own a home, using all your savings to purchase another residential property would be a big step away from a diversified portfolio.

The next step is to diversify within the asset classes.

That means your share portfolio shouldn’t be exclusively Australian banks or electricity companies, but should have an exposure to several industries.

Investors should then consider investing in different markets. As ASIC notes, Australia only holds a small part of the world’s investment opportunities. As of January this year, its market capitalisation represented just 1.7 per cent of the world’s total share market value.

“Investing some of your money overseas will reduce your exposure to a single market. Different markets will also peak at different times, for example, Asian or US markets might be up when Australian markets are down,” ASIC explained.

“Investing some of your money overseas will reduce your exposure to a single market.”

“Be aware that when you invest in international markets you have the added risk that changes in currency exchange rates can increase or reduce your investment returns.”

Another challenge with investing in overseas markets is gaining access. It can be an expensive process.

However, managed funds, exchange-traded funds and different superannuation funds often offer exposure to international markets.

Then what do I do?

Watch and wait. Once you’re happy your portfolio is sufficiently diverse across sectors, assets and markets, your job is to review it regularly.

The rate at which you review your portfolio depends on the type of investment. If you’re choosing to invest in a diversified managed fund, an annual review may be enough to ensure the returns and allocation are still appropriate.

If you’re investing in shares then you’ll need to monitor them more closely, making sure to stay abreast of any announcement that could affect your investments.

If you’re unhappy with the way your portfolio is performing, you can rebalance to maintain the desired mix of asset classes and exposures. This means selling assets you have too many of and investing in other areas where you think you’re falling short.

Make your money work with Yahoo Finance’s daily newsletter. Sign up here and stay on top of the latest money, news and tech news.