Diversification is a fairly easy concept. You spread your assets across different sectors of the economy so that if one sector rises and another falls, you get a smoother and more balanced return.
But that is just the start of diversification. True diversification means holding a range of asset classes that have uncorrelated drivers of performance, and also geographically, as regions and country's perform differently through the economic cycle.
So what should you do?
Let’s start with a share portfolio. It is good to be diversified and exposed across different industries. So you may start with a resource company and a bank to get exposure to key sectors of the economy, and then add in a transport stock, bio-tech company and a retailer, just as an example.
By spreading your portfolio across different sectors you aim for near full exposure to the economy. You may also add in filters to ensure your portfolio match’s your personal values with an ethical, social and governance framework (ESG).
Now it’s time to diversify across asset classes
Apart from shares the main asset classes are property, bonds, cash and currencies. Other possibilities include private equity, hedge funds and alternatives.
Essentially, you want to build a portfolio of assets where the drivers of performance differ. There is little point adding an asset class that is impacted by the same drivers that determine share market movements, as you won’t be achieving the purpose of diversification.
Let look at some of the main investments in the diversification toolbox:
Simple product that is useful if you just need to park some cash for a period of time. Highly competitive market, so shop around to get the best rate you can. However, official interest rates are near zero and the Reserve Bank of Australia has made it clear it does not expect interest rates to rise until at least 2024, so additional asset classes are more important than ever.
As with a standard term deposit, bonds offer access to predictable cash flows by way of regular interest payments, which in the bond world are known as 'coupons'. While government bonds offer little or no capital growth in ultra-low interest environments, there are good options in investment grade and high-yield corporate bonds.
Bonds are acknowledged as a prime avenue for capital preservation, and typically are not correlated to stock market movements.
Investors are also not restricted to Australia. Corporate bonds can be sourced from companies across the globe, and offer opportunity for currency diversification.
Like with any investment, investors need to ensure they are aware of any risks associated with the investment, and ensure such investments fit their risk tolerance. Ensure the supplier of any product you are interested in can answer all the questions you have about the product before making an investment.
Most investors use a combination of bonds and equities to construct a diversified portfolio, however, savvy investors are also including US dollar (USD) assets or other currency options into the mix. While currency is not an asset class in its own right it can be used to enhance returns and provide additional exposure to diverse income streams.
In times of market uncertainty the USD is often a currency of choice as it is considered a safe haven currency, providing it with an inverted correlation to equities.
Historically when equities have declined in value, the USD has appreciated and offset part of the volatility from equities. It allows investors to benefit from higher yielding bonds and structured notes, with lower volatility risk and potentially higher gains.
As the graph below shows, it can have a dramatic impact in times of uncertainty and volatility.
The more assets are uncorrelated within a portfolio, the lower the total portfolio volatility. This has become more important than ever, given the degree of uncertainty in the global economy.
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If you don’t want to take a position on where the share market is headed, or alternatively, if you have a strong view on where you expect the market to move, you can tailor an investment to benefit from that view.
These types of structures can also give access to global or country specific sectors in areas that may not be easily accessible on the Australian Stock Exchange, like US technology and healthcare investments. It can also provide currency hedging opportunities for your portfolio.
Another benefit is downside cover against market volatility unless there is a substantial market shift against your position. Normally the downside cover is for a 30-40 per cent shift, and it will also have to be down that much at the time your investment matures. You will not be impacted if it falls below your cover level, but rises again during the term of the investment, which is typically three years.
There are other risks with structured investments, like the issuer becoming insolvent, in which case the holder of a structured product will be treated as an unsecured creditor.
However, the level of overall risk will vary, depending on how you want to structure the investment. If you are interested in a structured investment it is important to fully understand the risks associated with any investment you consider. Again, ensure your supplier can provide a full breakdown of the product and explain any associated risks.
Australian’s love the property market, and it’s been a long held dream by many to own their own home by retirement. For many Australian’s, the largest asset they own is equity in their home.
Property, both commercial and residential, can also be a good investment opportunity, although investors need to be aware of how unexpected events like COVID-19 can impact rental returns.
However, it’s important to remember it’s generally considered a long term investment, and if you need to sell during a downturn, the market can suffer liquidity issues making a quick sale potentially difficult. Property is considered an ill-liquid market.
It's important to be aware of how much risk you are willing to tolerate, how much risk you can afford to take, and whether your portfolio is diversified appropriately for that level of risk.
Diversification won't provide complete protection from short-term dips and market volatility, but over the long term it’s the proven method for protecting and growing your wealth.
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This information is not advice and has been prepared without taking account of the objectives, situations or needs of any particular individuals. Any individual should consider if the information is appropriate for your own situation. Individuals are advised to obtain independent legal, financial, foreign exchange and taxation advice prior to making financial decision. Past performance is not indicative of future performance. Citigroup Pty Limited ABN 88 004 325 080, AFSL and Australian credit licence 238098.