When it comes to investing, the main asset classes are cash, fixed interest, property, and shares.
Importantly, each asset class (and sub-asset class) has its own unique characteristics (e.g. categorisation, focus, liquidity, expected rate of return, returns, risk level, and time horizon).
Moreover, no one asset or type of asset provides the best performance over all time periods—they tend to rise and fall at different times depending on economic, political and market factors.
With this in mind, diversification, or spreading your risk, is a key risk management strategy used when constructing (and maintaining) an appropriate investment portfolio, whether it be inside or outside of super.
In broad terms, diversification may be thought of as ‘not putting all your eggs in one basket’.
Diversification can be applied by spreading your funds across asset classes, inclusive of a wide range of sectors, industries and geographical regions within each of these asset classes.
Let’s look at diversification in terms of shares for example. Shares can be classified into geographic regions such as Australian shares (domestic), US shares or Asian shares.
Shares can be further classified into sectors and industries. For example, in the Global Industry Classification Standard (GICS), there are 11 sectors, 24 industry groups, 69 industries, and 158 sub-industries.
For context, the GICS assigns a share (company) to a sub-industry, and to a corresponding industry, industry group, and sector, according to the definition of its principal business activity. Here are two examples below:
So why is diversification an important strategy? By applying diversification, you can potentially reduce the volatility of your overall investment portfolio returns and ensure there is not a concentration heavily weighted in one area. This may help reduce the impact of a downturn in a particular market, industry, or region.
Concentration risk is the increase in investment risk that can come from a lack of diversification e.g. too much of your portfolio concentrated in too few assets, sectors, industries, or geographical regions.
For ease of reference (and comparison with diversification), in broad terms, concentration risk may be thought of as ‘having too many of your eggs in one basket’.
An example of concentration risk can be found in recent data on self-managed super fund (SMSF) asset concentration, which was highlighted by the Australian Taxation Office (ATO). For example, at 30 June 2018*:
Also of note, the ATO highlighted that the average SMSF investor is highly concentrated in domestic investments (home bias)—and, in particular Australian shares, property and cash.
In terms of Australian shares as an example, not only is the Australian share market concentrated, it’s small by global standards, representing less than 2% of the world’s investment opportunities by market capitalisation.
Concentration risk in general can arise from the outset (intentionally or not) or over time through asset performance. In terms of the latter, an asset may perform very well relative to other assets in your investment portfolio—leading to it representing a much greater percentage of your investment portfolio than before.
Concentration risk aside, if this isn’t monitored and acted upon accordingly when required, you can find yourself inappropriately invested e.g. invested with a level of risk that you aren’t willing and able to take.
One way to counter this can be through investment portfolio rebalancing. In broad terms, rebalancing is the process of rebalancing your portfolio’s asset allocation back in line with your chosen asset allocation strategy.
As discussed in our article, ‘Why rebalance an investment portfolio?’, there are several different types of rebalancing strategies that can be employed to counter concentration risk arising from asset performance:
Furthermore, how an investment portfolio rebalance is applied can be approached in several different ways:
When it comes to investing, it’s important to remember the fundamentals so you are invested appropriately—according to your financial situation, goals and objectives, now and in the future.
With this in mind, diversification is a key risk management strategy used when constructing (and maintaining) an appropriate investment portfolio, whether it be inside or outside of super.
Diversification involves spreading your funds across asset classes, inclusive of a wide range of sectors, industries and geographical regions within each of these asset classes. This can help to, for example:
After reading this article, you may find the following of interest:
Also, take the time to check out the section on diversification within our Investments learning module.
If you have any questions regarding this article, please contact us.
*ATO. (2020). Self-managed super funds: A statistical overview 2017-18. Table 31: Asset Concentrations.