Diversification is fundamental in the world of investing. It involves spreading your risk across multiple assets and asset classes, ensuring you’re not putting all your proverbial eggs in one basket. One way we achieve this is by building a diversified investment portfolio.
But what does that actually mean, and why does it matter? Let’s break it down.
What is a Diversified Investment Portfolio?
A diversified investment portfolio is a mix of different types of assets.
When I was a kid, I collected basketball cards. I didn’t just collect one card or one player, I spread my collection across lots of different cards and players. That not only made collecting more fun, but it gave me a better chance of holding onto a card that would one day be considered rare and valuable.
That’s what diversification does for your investments: it balances them out, helping you weather the ups and downs of the market by spreading your money across various assets.
Types of Assets in a Diversified Portfolio
A well-diversified portfolio generally contains two main asset classes: growth assets and defensive assets.
Growth assets, mean that your capital (the money you put in) is at risk. These have higher risk but also higher potential returns. Common growth assets include:
- Shares/Stocks: When you buy a share you are buying a business and as a part owner of that business you will ride the wave of its success. Pick a good business, make money, pick a bad business and, well, you can guess what happens…
- Property: This can be anything from privately owned residential real estate to listed property.
- Infrastructure. Like property, infrastructure involves tangible assets. However, instead of homes or buildings, you’re investing in essential services like toll roads, airports, and power grids. These can provide stable, long-term income streams due to their crucial role in everyday life.
- Alternative Investments: Alternative investments is a mixed bag – those assets or investment strategies that don’t fit into the traditional asset classes such as shares and property. This can be things like private equity, venture capital, commodities or even unique investment styles such as a long-short strategy. Alternative assets can be beneficial in a portfolio as they provide returns uncorrelated to the market.
When investing in the above asset classes you need to expect volatility to be part of your investment journey. To balance out the volatility, we turn to defensive assets.
Defensive assets are your ‘sleep well at night’ holdings. They’re low risk, low return, and are designed to protect the value of your capital. Key defensive assets include:
- Bonds: When you buy a bond, you are essentially lending someone (either the government or a corporate) money. In return, they give a coupon which is equivalent to an interest payment.
- Cash & Cash Equivalents: Things like savings accounts, term deposits, or money market funds. They provide quick access to cash but don’t usually offer much growth.
Matching Assets to Your Risk Profile
The split between how much you hold in growth assets vs defensive assets should be determine primarily by your comfort level for risk and your investment timeframe. To help guide people through this, we use a risk profiling process.
Risk profiling involves answering a series of academically validated psychometric questions (fancy way of saying relevant questions put together by smart people). It is an immensely important step in the financial planning process as it sets the expectations for your portfolio.
Are you expecting a high potential return and willing to accept the volatility that comes along with it? Or are you more concerned about protecting what you already have and are willing to accept a more modest return?
In financial planning, we typically classify investors into one of five risk profiles. These range from conservative investors who prefer steady returns to more aggressive investors willing to accept significant risk for higher potential returns. Or as we like to say, from the ‘I drive 10 km below the speed limit’ type to the ‘I’ll skydive without a parachute if you promise to catch me’ type!
The Pros and Cons of a Diversified Portfolio
While diversification can be a powerful tool, it’s not without its own quirks. Let’s take a look at the benefits and drawbacks.
The key benefits of a diversified investment portfolio include:
- Risk Reduction: By spreading your investments, you’re less likely to experience severe losses if one asset type performs poorly.
- Steady Returns: With a balanced mix, you can potentially achieve smoother returns over the long term.
- Flexibility: You can adjust your portfolio as your goals and risk tolerance change over time.
But it’s not all roses, there are some drawbacks including the following:
- Potentially Lower Returns: Diversification might mean that you miss out on the full upside if one asset skyrockets.
- Increased Complexity: Managing a diversified portfolio requires monitoring multiple asset classes, which can be time-consuming and require more expertise.
- Costs: More assets often mean more transactions, which can lead to higher fees and taxes.
The Guided Investor approach
Here at Guided Investor, we have refined our investment philosophy and believe that a personalised strategy is the cornerstone of successful investing. We work closely with clients to align their portfolio with their unique goals, risk tolerance, and financial aspirations. Our philosophy ensures that every portfolio is not only diversified but also strategically aligned with each client’s financial journey
While we believe strategy always comes first, investing is a tool we use to implement strategy. This tool becomes very important in Phases 2 and up of the Wealth Creation process.
