Diversification is one of the most widely accepted principles in investing. The idea is simple: by spreading investments across different assets, the poor performance of one holding has less effect on the portfolio as a whole. In practice, diversification requires thought, because not all spreading is equally effective.

Why diversification matters

Different investments respond differently to economic conditions. When shares fall, some other assets may hold their value or rise. When one sector struggles, another may prosper. By holding a range of investments whose returns do not move perfectly together, investors can reduce the overall variability of a portfolio without necessarily reducing its expected long-term return.

Diversification is particularly effective at reducing investment-specific risk — the risk associated with a single company or issuer. It is less effective at reducing market-wide risk, which tends to affect many assets at once.

Dimensions of diversification

Diversification can be approached across several dimensions:

  • Asset class — cash, fixed income, shares, property, private investments and alternatives.
  • Sector — financials, resources, healthcare, technology, consumer and others.
  • Geography — Australian and international markets.
  • Issuer — avoiding excessive exposure to a single company or borrower.
  • Liquidity — balancing investments that can be accessed quickly with those that cannot.
  • Time — staggering maturities or investing over time rather than all at once.

The Australian context

The Australian share market is relatively concentrated, with a significant proportion of its value in the financial and resources sectors. An investor who holds only Australian shares may therefore have more sector concentration than they realise. International shares and other asset classes are commonly used to broaden that exposure.

Many Australians also hold significant wealth in residential property and superannuation. A complete view of diversification considers all of these holdings together, not just the investment portfolio in isolation.

What diversification cannot do

Diversification does not eliminate the possibility of loss. During periods of severe market stress, many asset classes can fall at the same time, and relationships between investments can change. Diversification also cannot turn a poor-quality investment into a good one.

It is also possible to over-diversify — holding so many investments that the portfolio becomes difficult to monitor, costs rise, and the benefit of each additional holding becomes negligible.

Reviewing over time

Portfolios drift as some investments grow faster than others. Without periodic review, a portfolio that started out diversified can become concentrated. Reviewing allocations against objectives — and rebalancing where appropriate — is part of maintaining a diversified approach.

This article is general in nature and does not take into account your personal circumstances. Consider seeking independent professional advice before making investment decisions.