The different dimensions of diversification
9 April 2021
There’s one basic idea behind diversifying your investments: by investing across lots of different things, you spread your money around, which means you take less of a hit if one of those investments loses value. It’s like the old cliche, “don’t put all your eggs in one basket”.
That’s all well and good in theory, but what does that actually look like in practice? We thought we’d give a few ideas around how you can actually make diversification happen in your portfolio—and what you might want to think about when you do.
Dimensions of diversification
Just like a shape has length, width, and depth, your investments can have different dimensions as well. Here are a few ones to get you thinking:
The number of things you invest in: e.g. lots of different investments, one investment, or somewhere in between.
Geography: e.g. investing some of your money in companies in Australia, and some of your money in companies overseas.
Sector: a group of companies in the same general area (e.g. the mining sector). By investing your money in many different sectors, you’re insulating your portfolio from the risk of a big change in one specific sector (e.g. the price of minerals goes down and the mining sector takes a hit).
The kind of investment, also known as asset class: e.g. shares, bonds, cash deposits.
Using the numbers
One way to diversify is to invest in a bunch of different investments. For example, you could invest a little bit of money in each of the top 200 companies on the Australian Securities Exchange (ASX). If you did this, you would be diversified across all different kinds of companies.
Some of the companies are riskier than others, so you’d also be diversified across this dimension—if one of the riskier ones starts to decrease in value, the other 199 might be able to help prop it up. This would only be the case if one company performed worse than the rest of the market. If the entire market dips, then diversifying across lots of different companies might not be that useful.
For example, many of these companies do business in Australia. If something happened to the entire Australian economy, you might be a bit vulnerable.
If you wanted to be a bit more diverse, you could diversify geographically as well. You could do this by investing in things in a variety of different countries or regions. This approach protects you from the ups and downs of regional economies. For example, the US economy might dip a bit, while Australia’s economy trucks along with no problems—or vice versa. If you’re invested in things in both regions, it might take the sting out of those local economic dips.
There are all kinds of exchange-traded funds (ETFs) and managed funds that specialise in certain areas, so you could distribute your money across a couple of these. On top of that, there are ETFs and managed funds that specialise in very large areas—like the entire world! If you invested in just one or two funds that invests in companies all over the world, that portion of your portfolio might be very geographically diverse.
Diversifying across sectors
You can also diversify by choosing different sectors in the economy. For example, you might buy some shares in an electricity company, some shares in an airline, and some shares in a construction company. By investing across three different sectors, you’re spreading your risk—that way, if something were to happen in one sector, you’d still have investments in two others.
Of course, this is just a hypothetical example—the actual economy is a lot more complicated than that. But it’s a good way to see how investing in different sectors can bring you more diversification.
Investing in a variety of investments like this gives you diversification across sectors, which limits your exposure to any one sector. If you invested in an ETF that specialises in the property sector, and some in ETFs that specialise in other sectors, you would be less exposed to risks that affect the property sector specifically—such as increasing construction costs or dropping property values (compared with if you only invested in an ETF that specialises in the property sector).
Diversifying across asset classes
Then there are asset classes. An asset class is just a way of categorising investments. The easiest example to think of is shares and bonds. Shares are one asset class, while bonds are another asset class. They’re structured differently, and they give different returns.
Asset classes around the world can sometimes move as a pack. So while investing in shares in different companies, regions, and sectors may protect you from individual movements, it doesn’t protect you from a global dip in all shares.
One way to reduce your exposure to a single asset class losing value is to invest in other asset classes as well. For example, splitting your portfolio across shares, cash, and bonds. This gives an extra layer of diversification, because bonds pay a regular income where shares can be much less predictable.
What’s the catch?
Diversification is ultimately related to risk. The more risk you take, the bigger rewards you might be able to get, but the higher your odds are of losing your money. If you put $100 in a savings account, you might make just a few dollars a year, depending on the interest rate. But at the same time, you wouldn’t be taking much risk. If you spent $100 on lottery tickets, you’d almost certainly lose your entire $100, but there’s a (very) small chance that you’d get tens of millions of dollars.
Diversification is similar. If you invest all your money in one company, and that one company does really well, then you will get solid returns. But if that one company goes under, you’ll lose everything. Ouch!
Now let’s say you invest your money in that original company, plus a thousand more companies. Now, that company only represents 1/1000th of your investment, rather than the whole thing—so if it increases value, your total percentage return will be much smaller than it would have been—but if it drops in half, your total loss will be much smaller, as long as the rest of the market doesn’t drop by the same magnitude.
Now imagine you invest in 10,000 different companies, or 100,000 different companies, with a bunch of bonds thrown in for good measure. The more you diversify, and the more dimensions you add, the more you spread your risk.
Where to from here?
By adding different dimensions to your diversification, you spread risk more than you would by just investing in lots of different things.
The trick is to look at your investments and ask yourself how each one would respond to the same event. What would happen to your portfolio if the Australian economy had some problems? Or if oil went up in price? Or if there was a global share price decline? And so on, and so forth. Think of some big picture scenarios, and ask yourself how they’d affect your investments.
Then, if things are looking unbalanced, you might want to take some steps to balance things out. You can spread your risk around as much or as little as you’re comfortable with, and tailor your portfolio to achieve your goals.
Ok, now for the legal bit
Investing involves risk. You aren’t guaranteed to make money, and you might lose the money you start with. We don’t provide personalised advice or recommendations. Any information we provide is general only and current at the time written. You should consider seeking independent legal, financial, taxation or other advice when considering whether an investment is appropriate for your objectives, financial situation or needs.