What is diversification?

We've all heard the saying "don't put all your eggs in one basket"! 

This is an important strategy when investing. If investments are spread across different asset classes, then your strategy is diversified. Read on to understand why this matters.

The key points we cover in this article are:

• Risk versus return
  
• How diversification works
  
• Dimensions of diversification
• Diversification and super

Risk versus returns

Why does anyone invest when there’s a risk they could lose money? In short: to make more money, also known as 'returns'.

But what if you could lower certain risks and benefit from potentially higher returns? We’ve long been taught that there’s no such thing as a free lunch, but Nobel prize winning economist Harry Markowitz famously said, “diversification is the only free lunch”.

That’s because a diversified portfolio aims to increase returns without adding risk. The strategy can work because different assets often do well at different times. When one investment performs poorly, another might perform well.

How diversification works

Investing is a lot more fun and rewarding if you can avoid losing money too often. But we know assets  sometimes decline in value.

By combining different assets, we can build a portfolio of investments where the negative performance of some might be offset by the positive performance of others. Put simply, diversification aims to soften the blows and smooth out the journey.

For example, if you invest in company A and that company goes through some challenging times, its impact on your overall investment portfolio will be less if you have invested in several different assets.

If you're looking to reduce risk as much as possible, spreading your portfolio across a range of assets that behave differently in different market cycles should help you capture the greatest diversification benefit, by aiming to:

• reduce risk
• decrease volatility, and
• smooth returns.

Conversely, investing in assets that behave very similarly will provide limited diversification benefit.

Dimensions of diversification

Investors can seek to manage the risk level by diversifying their portfolio in many ways:

• Number of assets — you might own one, several, or many assets.

• Asset class — you might invest in shares, bonds, property, cash, and/or alternatives.

• Geography — you might hold investments in Australia, or across different continents like Asia and Europe.

• Industry — you might invest in several different sectors, like finance, agriculture and technology.

• Time — you might invest your funds over time instead of all at once. For example, if you invest $1,000 a month for 12 months, rather than $12,000 all at once.

• Strategy — you might choose different investment styles, each of which may perform better than others under certain conditions.

How you choose to diversify depends on the level of risk you’re comfortable taking. For example, if you have a very high tolerance for risk, you might put all your money in the shares of one company. If that company does well, you’ll be handsomely rewarded. But if the company goes bankrupt, you may well lose your entire investment.

For super, it’s generally uncommon for someone to take this level of risk with their retirement savings. There are also regulations that prevent you from putting all of your super in a single asset.

When choosing investment options, you should decide how much risk is appropriate for you, based on your personal circumstances and tolerance for risk.

To help our members achieve their best personal retirement income, Rest uses a range of risk management strategies – and diversification is one of the most important.