Diversification: The foundation of a solid portfolio
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Peter Gee is a research products manager at Morningstar.
It is well recognised that avoiding large losses remains a key element in building wealth. The focus on capital preservation is warranted as heavy losses require very high rates of return to restore the original capital. For example, a 100 per cent gain is required to recoup a 50 per cent loss.
Exhibit 1 shows the annual returns of each of the four major asset classes over a 40-year period. The asset classes are arranged in descending order of return so that the best-performing asset class is at the top and the poorest performing asset class is at the bottom.
It is clear from the "gameboard" that no single asset class either outperforms or underperforms consistently. The largest recorded annual fall in the 40-year period was property with 55.3 per cent.
So how do we avoid the extreme losses to capital?
Exhibit 1: Gameboard Chart Featuring Asset Class Returns Over a 40-Year Period
Source: Morningstar Direct
Diversifying or spreading investments across multiple asset classes reduces an investment portfolio's overall risk. This is because losses made in one asset class can be offset by gains in others.
Exhibit 2 illustrates this point using the 2012 financial year returns, a period where Australian equities lost 6.7 per cent (it's important to note that the past results may not be necessarily repeated in the future).
By combining the Australian equities portfolio with Australian fixed interest portfolio in a 50/50 split, the combined portfolio benefitted from the offsetting returns and gained 2.9 per cent.
Investing in multiple asset classes therefore reduces the likelihood of any single asset class adversely affecting the value of an investment portfolio and theoretically smooths the return profile.