Why you should diversify your portfolio and how to do it


Volatility is just part and parcel of investing, but there is a method that many investors use to smooth out their ride: diversification.

The rotating success of various asset classes in the last few years alone showcases how volatile markets can be," says Duncan Burns, Vanguard's chief investment officer for the Asia-Pacific region.

"If you look at annual asset class returns for the last few years, the best performer in 2022-23 was U.S. shares which were up a little over 23%.

what is diversification in investing and why does it matter?
Building an investment portfolio? Diversification could be key. Photo: Getty Images.

"But if we go back to the year prior cash was the best performer, and the year before that it was hedged international shares for Australian investors."

So when it comes to building an investment portfolio, what do investors need to know about diversification?

1. Why does portfolio diversification matter?

At the heart of diversification is the goal of minimising the chances of an investment decreasing in value or, at least, limiting the extent of that decrease. As Burns explains, it's all about lowering risk.

"It really all started with modern portfolio theory which is when investing jumped into becoming a science back in the 1950s," he says.

"Harry Markowitz, who was a Nobel Prize winning economist was the father of that and the takeaway of his work is that more diversification is better than less. I think the easiest way to explain that is that diversification lowers investment risk.

"A quote I find quite helpful when I'm trying to explain this to my mum and dad is that 'It's not about holding a lot of different things, it's about holding a lot of different things that react differently to the same phenomenon.'"

In practice, that can mean bringing different assets - the likes of stocks, bonds and cash - together in the one portfolio to help produce more stable returns.

Glen Hare, a financial adviser and co-founder of Fox and Hare Wealth, says that smoothing out the bumps can be a great benefit of diversification, but he also recommends that investors approach it with their broader goals in mind.

"It's really important that investing is in line with what we're actually trying to achieve. So if that's buying a home in the next 12 months, then that might mean having a significant portion of your net wealth in cash because you'll need that to enable you to pull the trigger and put down a deposit.

"If you're looking at building longer term wealth then you might look at investing more in high-growth assets such as shares which, if history is anything to go by, will outperform money in a bank account over the long term."

2. How can investors go about diversifying their portfolios?

At the highest level, one of the ways investors go about building a diversified portfolio is by investing money in a mix of asset classes such as bonds, cash, property, shares and more. Then, as Hare explains, there are options for diversifying within a particular asset class.

"Thinking about shares specifically, one of the biggest advantages of investing in the stock market is the ability to diversify. That's based on being able to invest in companies of various sizes, whether they be large caps like Amazon and Google or smaller, more speculative stocks.

"Then there's having exposure to different geographical locations. Another advantage of investing in the stock market is that you don't just have to invest in companies based here in Australia, you can look at companies in emerging markets, America and Europe as well.

"And then there's also diversification around sector. So looking at the technology sector, versus health care, versus consumer staples and providers of your day-to-day goods."

3. Does diversifying require lots of time and money?

Ultimately, Hare says that while having access to more capital can make it easier to build a diverse portfolio, it doesn't need to be a significant amount of money.

In the world of shares that's down to, in part, the evolution of products that have made obtaining a share of one company, or many companies, simpler.

"It is achievable with smaller amounts. There are investment platforms that allow you to buy a fraction of expensive stocks and build a diverse portfolio that way," says Hare.

"And then there's also structures that enable us to have access to diversification, the really obvious ones being exchange traded funds which have grown exponentially in popularity, and then your more traditional managed funds."

As one of the world's largest exchange traded fund (ETF) and index fund providers, Vanguard naturally sees the potential such funds having in helping investors diversify - diversification that, Burns says, doesn't require an excess of time or capital to achieve.

"The tools that everyday investors have today are game changers. So gaining exposure to something broad like the ASX or international shares is really easy and that's largely thanks to ETFs and index funds."

"If you were to pick a couple of ETFs you could quite quickly piece together a diversified portfolio at very low cost, and you can actually do that with a surprisingly small amount of money."

4. Is it possible to over-diversify a portfolio?

During the early stages of the pandemic, first-time investors flocked to the share market to try their hand at investing. One of the legacies of this enthusiasm that Hare has come across firsthand though is investors who have ended up over-diversifying.

"What some people have ended up with is a portfolio that's diverse in terms of being across 20-30 different companies, but it may not necessarily have any clear direction.

"The other challenge that I certainly see is that if you are invested in a number of different funds and direct shares, there's a chance that you've duplicated your exposure. That's why it's really important to look under the hood and understand if there is any duplication across the portfolio as a whole."

Burns shares the opinion that investors need to be wary about the risk of doubling-up.

"Diversification is about getting the right mix of securities. Going back to that quote, it's not about buying a lot of different things, it's about buying a lot of different things that react differently to the same market phenomenon.

"So adding too many investments that are going to overlap with what you already have is going to be detrimental to the portfolio and could actually end up increasing your risk instead of decreasing it."

5. How can investors approach rebalancing?

When Burns talks to clients about maintaining a healthy portfolio he likes to use the analogy of a car needing regular servicing in order to stay in good running order. An important part of this is rebalancing.

"Markets are constantly moving, so once you're diversified and you've got a target portfolio in mind, rebalancing back to that target is key.

"Just looking at equity moves in the last year, if I've got a multi-asset portfolio and I haven't rebalanced there's a pretty good chance I'm overweight equities right now and I may be drifting away from my target risk profile. So I'd want to sell some equities and buy some bonds."

So how can investors approach rebalancing? Burns says there are a couple of options.

"It's important to have a rebalancing strategy. That could be rebalancing on a recurring basis, like once every year, or it could be based on how far an asset allocation is allowed to deviate from target - for example, if things have moved 1%, or 2% or 5%."

Similar to over-diversifying, Burns does encourage investors to avoid going overboard with their rebalancing though, because taxes, transaction costs and the time and effort involved are all important factors worth weighing up.

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Tom Watson is a senior journalist at Money magazine, and one of the hosts of the Friends With Money podcast. He's previously worked as a journalist covering everything from property and consumer banking to financial technology. Tom has a Bachelor of Communication (Journalism) from the University of Technology, Sydney.