What is portfolio diversification?

By Sam Osborne, Director, Capital at PE Capital

 

A recent report commissioned by a large financial services group highlighted that many SMSF portfolio’s are not as diversified as their trustees believe.

 

A common misunderstanding is that portfolio diversification can be achieved by investing in a large number of different ASX listed shares. Particularly if those shares provide exposure to different sectors of the share market, for example, banks, mining, agriculture, manufacturing, etc.

 

From the report, it appears many SMSF trustees wish to have a more diversified portfolio but;

 

(a) they don’t know why

(b) they don’t know what “diversification” actually means

and (c) they don’t know how to achieve diversification

 

To answer each question individually.

 

(a)    Why? The reason why asset class diversification (as distinct from equity sector diversification) is important is that it reduces portfolio risk. To put it simply, when the share market falls, generally the whole share market falls, not just a particular sector. Therefore, as an investor in the share market, your whole portfolio has fallen in value. By reducing portfolio risk, the portfolio should not suffer the large falls which are typical of more concentrated portfolio allocations.

(b)    What does “diversification” mean? As illustrated above, diversification does not mean “diversified across different sectors of the share market”. It actually means diversified across different asset classes.

(c)    How can SMSF trustees achieve a truly diversified (by asset class) portfolio?

 

First, we need to understand what the different asset classes are. Then we need to understand how SMSF trustees can gain access to the different asset classes.

 

To address this, SMSF investors should study the approach professional asset allocators take to combat portfolio risk. These professionals, who include fund managers and advisers, allocate funds across a wide range of asset classes. These include:

 

·         domestic shares

·         international shares

·         fixed interest

·         real estate

·         government bonds

·         commodities

·         cash

·         private equity

·         hedge funds

·         currency

·         derivatives

·         venture capital

 

 

 

Gaining access to different asset classes can be achieved through the following means:

 

·         Managed Funds

·         Exchanged Traded Funds (ETF’s)

·         Direct shares

·         Real Estate Investment Trusts (REIT’s)

·         Listed Investment Companies (LIC’s) and Listed Investment Trusts (LIT’s)

·         Private syndicates

·         Term Deposits

·         Cash Management Accounts

 

Obviously, each SMSF trustee will have different needs, views and preferences around asset allocation and how they choose to achieve their desired investment exposure. The crucial thing to remember is that true diversification lowers portfolio risk and this can only be achieved by diversifying across asset classes, not just across sectors in the share market.

 

Next week I will be discussing the benefits of portfolio diversification.

 

If you’d like to learn more on this or other relevant topics, please look around our website or contact Sam directly on so@pecapital.com.au