Diversification – what does it really mean?

Posted on 5 July 2017

To really be able to answer this question we will need to delve in the different types of investments we have available to us.

But essentially to diversify means to invest in different asset classes – to ensure you don’t invest all your money in one asset class or as some may refer to it “put all your eggs in one basket”.

Let’s take a closer look.

What is an asset class?

While you may not have specifically heard the term asset class you have probably heard of the different asset classes under their real names: cash, bonds, property and shares.

An asset class is simply a group of investments that share similar characteristics, behave similarly in the market and are subject to the same rules and regulations.

Most importantly, each asset class comes with different risks and will produce different returns over various time periods. And understanding how each works will help you make better investment decisions.

The main asset classes are:

Cash

Cash includes bank deposits, term deposits, savings accounts and cash management trusts. Cash is thought of as the safest asset class and while returns are currently at all-time lows, you do still receive a return on your investment, you just need to shop around to try and make sure you are maximising the return you receive.

Cash alone won’t provide you with the best investment gains over the long-term. It’s easily accessible, but the big risk is that inflation can eat up most of its returns, especially in low interest environments (like we have right now).

Bonds or fixed income

Similar to a loan, bonds involve lending money to companies, governments or against mortgages for a set period of time in return for regular interest payments.

While they are relatively safe and provide a reasonable return for your money, bonds do come with risks. The most important is that if interest rates rise, the value and yield of your bond will fall. Another risk is that the issuer will not be able to repay its debts (i.e. your loan to them). For this reason, government bonds are considered safer than corporate bonds. But to make up for the risk, corporate bonds pay higher yields.

Bonds can play an important role in your overall investment strategy and can smooth out market volatility, but used alone, they will not provide you with the highest returns over the long-term.

Shares (equities)

These allow you to own a piece of a company and can be bought on local or overseas exchanges, or via exchange traded funds (ETFs) or managed funds.

Returns are typically generated by the growth in the share price and dividends (which may be franked because the company has already paid tax on its earnings).

While shares are also easy to buy and sell, they are also one of the most volatile asset classes. Share markets are influenced by a wide range of factors both domestically and internationally. The company you invest in may also not perform well or go broke. But over the long term, shares have traditionally achieved better returns than the majority of other asset classes.

Property

This can include direct investments in residential, industrial and commercial property, but can also be done via listed and unlisted property trusts. These require a much smaller financial outlay and provide greater ability to diversify your holdings.

Property, like shares is a growth asset and therefore comes with higher risks than cash or bonds. Many believe that property is less risky than shares but we would argue that point.

There are those that favour Property over shares for the pure reason that it if you are investing in direct property it is tangible, you can see it and touch it, it feels real.

Some of the benefits of investing in property include, the gain you receive from a rise in the value of your property, the rental payments and, possibly, negative gearing, which is a tax offset on any losses you may have made.

The downside is that property’s entry and exit costs are much higher than other investments. In addition to the property price, you may have to pay real estate agents’ commissions, stamp duties and conveyancing fees.

Property investments also require far longer timeframes and are less liquid than other asset classes; it can take months to sell a property. You also face the risks of having the property vacant at times and you are putting most, if not all, of your eggs in one basket.

Other investments

A host of other asset classes can be accessed via shares, ETFs or managed funds. They include infrastructure – which includes investments in airports, toll roads, water and energy – and private equity (which invests in unlisted companies).

Diversification

Choosing which asset class to invest in will depend on a range of factors, including your goals, financial situation, investment timeframe and risk tolerance.

You are also going to be better off having a mix of different asset classes in your portfolio – that is, not having all your eggs in one basket. It’s been shown that having a portfolio of different asset classes usually produces both higher returns, lower risks and less volatility for most investors.

However, putting that mix together can be confusing, if you would like some advice on how this can be done, please contact the team at Vue Financial.