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2010-04-19, 10:28:36 return
The Importance of Diversification
You've probably all heard the phrase 'don't put your eggs in the same basket'. When it comes to investing, you don't put all your money in the same basket. In this article we'll look at the different investment 'baskets' and discuss our approach to diversification.

Why is diversification important

Everyone has a fear of losing money. We don't want to make investment decisions that result in loss of our capital. Diversification helps reduce the risk of that occurring.

Some investments have the potential to produce higher returns, but they also provide higher uncertainty over the short term. Other investments produce lower, but more stable returns.

The idea of diversification is to give you smoother and more consistent investment returns over time.

Principle #1 - invest appropriately for your time frame.

When we meet with you, we spend a while getting to know your goals and objectives. Any investment strategy we recommend has to be appropriate for you and give you every opportunity of meeting those needs and objectives.

If you have financial goals that are short term (under 3 years) we'd generally suggest cash investments - bank accounts and term deposits etc. Whilst these investments won't produce high returns, your capital remains stable.

If your goals are longer term, you can introduce investments that have the potential to provide better returns over that time frame - shares and property. You wouldn't invest in shares for a one-year time frame - it's too risky. Conversely, having all your money in cash over a 10-year period is also risky - it'll barely keep pace with inflation after tax is paid.

So, depending on your time horizon, you could have some money invested in growth assets in order to gain the potential for better returns.

Principle #2 - Different eggs in different baskets

It's risky to have all your money in one investment - all in one property or in one share. If it does well, you could make some good returns, but what if it goes bad?

Good diversification involves having money invested across the different asset classes - some in shares, some in property, some in fixed interest and cash. The amount you place in each sector depends on your goals and objectives and the level of risk you're prepared to take in order to achieve your desired return.

Over time you'll see that each year different asset classes perform well at different times.

Principle #3 - Take from the good and give to the bad

We believe in the importance of re-balancing your portfolio.

Let's say we've recommended you have around 30% of your money invested in Australian shares. Over the next year Australian shares produce some great returns and now make up around 35% of your portfolio. We'd recommend you take some of the profits, and top up the under-performing sectors - if Australian shares now make up 5% more in your portfolio, other sectors will be below the recommended allocation in your portfolio.

This is a hard thing to do when things are going well. Maybe if Australian shares do well the next year you'll regret selling down in the previous year. But if that sector declines in value, you'll appreciate the advice we gave and the discipline in sticking to the recommended asset allocation.

Conversely, when Australian shares have a poor year and decline, we'll suggest taking money from the better-performing sectors to add to your Australian shares.

Principle #4 - Use different investment structures

When it comes to saving for retirement, for many people superannuation is the most appropriate investment vehicle for them. But the further away from retirement you are, the more likely it is that the super rules will change. Perhaps the change won't be major, but we believe it's risky to make major decisions on the assumptions that the same rules that apply today will still apply in 10 years when you retire.

We suggest you diversify across different investment structures. For retirement savings, we favour superannuation as the main vehicle, but we'd also suggest other investments such as managed funds and bank accounts.

If the rules change, you haven't committed all your eggs to the one basket.

Principle #5 - Don't concentrate

There's a danger in focusing your wealth accumulation on one investment. I've seen clients with one investment property and a huge mortgage struggle when they couldn't find tenants for 6 months. I've seen clients with large share holdings in one company (from an employee share scheme) see their wealth drop by 40% in the space of a few weeks due to the decline in the share price of that one company.

So spread your eggs around.

Imagine you've got money invested in 5 different shares. If one of those companies goes broke you've lost 20% of your capital. What if it was invested across 100 companies and one went broke? You'd only lose 1% of your capital.

Principle #6 - Remember the pencils

As a final example of the importance of diversification, think of this example.

Imagine you're holding a lead pencil in your hand. Bend it and snap it - it may take a bit of effort, but it is possible.

Now, take 20 pencils and hold them together in your hands. Bend them and try and snap them - you can't.
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