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What diversification means for your portfolio

Phillip Gray  |  07 Jan 2015Text size  Decrease  Increase  |  

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Phillip Gray is head of communications at Morningstar.

 

One of the most important principles of investing is called "diversification". Put another way, this means not putting all your investment eggs in one basket. Typically, certain types of investments will perform well at certain times, while others will not. An international share fund, for example, will generally perform well when international share markets are doing well, but fixed-interest funds will probably do better in subdued economic conditions.

So just how can you go about achieving this diversification? If you own a variety of investments in your portfolio, the diversity this provides gives you a greater chance of always having something that performs relatively well, no matter what the current market conditions.

The exact mix of investments in your diversified portfolio will depend on your reasons for investing -- your goals -- and your tolerance for taking risk. (Remember that every investment has some degree of risk -- the key issue is to make sure that you're comfortable with the level of risk you're taking. In the words of Warren Buffett, one of the world's most prominent investors: "Risk comes from not knowing what you're doing.")

You might diversify by holding funds investing in different assets such as shares, fixed interest and property, both within Australia and overseas. And try to get "under the bonnet" to find out as much as possible about which companies or securities your funds actually own -- without knowing this, you could actually be concentrating your exposure, rather than diversifying it. (For example, you might own direct shares in AMP Limited (AMP), but your managed fund may also own shares in these companies. In that case, you're actually increasing your exposure to those companies -- once through your direct shareholding, and then again through your managed fund.)

Let's say that you own five Australian share funds, offered by four different fund managers -- AMP, BT Investment Managmeent, Colonial First State, and Perpetual (PPT). That's diversification, right? Well, probably not.

Imagine that these five funds are boxes that open outwards, with all the company shares that the funds contain inside -- like the pieces of a jigsaw puzzle. Now tip open the boxes -- the funds -- so that all the pieces -- the company shares the funds own -- are in one big pile. It's likely that in that pile, you'll find a lot of jigsaw pieces the same colour (shares in the same companies). The trick is to try and ensure that you have as few similar pieces as possible. Because if your funds are too similar, and own the same securities, that means your exposure to the risks associated with those securities is even more concentrated. This is further highlighted in the article, 5 rules for a smart investment strategy.

Fund managers often publish lists of their funds' top 10 holdings. While this offers you some information, it's not enough. To avoid your portfolio becoming like a jigsaw puzzle (but only with the blue sky pieces), you need to be able to compile an entire share or bond breakdown for each fund, and aggregate them all, to understand the interaction between all the holdings in your total portfolio. Then you'll know which securities overlap each other, and what sort of balance you currently have in your portfolio. You can then figure out what your next investment move should be in terms of trying to spread your risk.

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