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What Does Diversification Mean To You?

What does diversification mean to you?

Mark Bouris April 8, 2012

There are a number of answers to the question and in the financial services industry we can talk at length about asset allocation, spreading risk and the risk-return curve.

But when Australians are talking about saving for their retirement, it’s their basic idea of the diversified portfolio that is most important, because it’s this personal sense of what’s right that ultimately decides where money is invested for the long term.

I was thinking about this recently because I put out a tweet asking where followers would put $10,000 for a year if I gave them the money.

At first, I was struck by the fact that two-thirds of the responses would put their $10,000 into shares, or property or cash.

But what really fascinated me about the responses I received was that not a single person told me that they would split the $10,000 and invest it in different asset classes.

No one wanted to diversify. No one said: ”I’d put $4000 into shares and $3000 into a property trust and $3000 into a fixed-interest account.”

And I had almost 70 people respond to me.

It might not seem so odd to readers but remember this: the funds management and financial advisory industries have spent the past 20 years emphasising the benefits of a diversified portfolio and spreading risk. And at the base of this diversified portfolio is the notion of asset allocation.

Allocating your investments by class means, typically, you devote portions of your capital to Australian shares, global shares, cash, property and bonds.

Within this general idea is the more complex business of matching the ratios of your allocation with what they call your ”life stage”: if you’re 20, your allocation will be heavier to Australian and global equities because the amount of time you’re invested will cancel out the volatility cycles and you’ll get higher returns.

Conversely, when you’re a retiree or a near-retiree, you shift the weighting of your allocation to be heavier in cash and fixed interest because, while they’re lower in returns, they’re high in stability.

While these dramatic shifts in asset allocation have become par for the course, I’ve been rethinking it lately.

For a start, when you shift your portfolio allocation to reflect your life stage – in the way I’ve described – there is a real danger that what you’re really doing is picking winners. And if this is the case, it’s no wonder that no one in my Twitter poll split the $10,000 into a class allocation: they were looking for the ”winner” rather than ”buying the field”.

Second, the notion of asset allocation by investment class has an extreme look to it. Two of the main risks are market risk and inflation. You expose yourself to market risk because chasing higher returns often means you’re invested in volatile equities that can drop in value very quickly.

Inflation risk occurs for the opposite reason: you’re chasing low risk, which means investing in cash that always hovers at very low margins above the inflation rate.

Third, we are encouraged to skew our retirement investments to either market risk or inflation risk by the ”default” options set by our superannuation fund managers. If you tick default, for most of your accumulation phase you’ll be invested 60 per cent to 70 per cent in equities. When you identify that you’re about to retire, most default funds switch you to a reliance on cash investments.

This is a pendulum approach.

In other words, what we understand as asset allocation might not spread the risk or match life stage to risk appetite quite as successfully as we imagine.

How do we stop the pendulum? How do we find the sweet spot in the middle?

One of the interesting facts many retirement investors are not told is that the asset class called bonds – halfway between the risk-return of equities and cash – is a better long-term performer than equities with very little volatility.

Not surprisingly, bonds are a popular long-term investment vehicle for institutions, wealthy individuals and high-net-worth family trusts. In other words, I believe the issue of asset allocation will be revisited in this post-global financial crisis market and we’ll come to see it as a chance to properly balance a portfolio from the outset rather than change the risk profile to match life stages.

Keep your eyes on bonds – they’ll be the key to the new asset allocation.

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