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Hedging your bets with diversification

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If you went to the Melbourne Cup – what sort of bet would you place? Show, quinella or superfecta? If you’re not familiar with the terms we’ll help you. Your best chance of winning something out of those choices would be a show bet, the superfecta is the hardest to win.

So if you prefer better odds and outcomes, diversification is a very good idea. This enables you to manage your investment risk and can be done in various ways, mainly:

1. Within each asset class

You can invest within each asset class. For example, you can invest in different types of property: retail, commercial and residential. This would mean you are holding similar investments within a single asset class – property. And because it’s all within one asset class, you’d expect the different types of property to have similar risks and returns.

If you’re new to the investment game, you might prefer a simpler explanation. Let’s agree that socks and undies are in the same asset class because they are called underwear and usually go in the same draw. If you only have one asset class (underwear) you are not diversified very well and will not be rewarded with good returns in winter if they’re the only assets you possess.

2. Across asset classes

By comparison, forks, chairs and a heater are all different and cannot be put in the same asset class (or draw) as socks and undies. This would make them asset classes in their own right and owning them means you have greater diversification in your home. And having more diversification in furnishings will return greater comfort.

The same can be said of holding all four major asset classes in your portfolio (cash, fixed interest, property and shares). You aren’t reliant on one asset class (your socks and undies) keeping you warm – you also have a heater. Those three assets combined will reward you with even greater warmth than socks and undies alone can. And if your undies rip, you can still sit in front of the heater and keep warm.

So as you can see, by investing (or buying) across different assets, you create a portfolio with which you can potentially offset, to some degree, losses in one asset sector with gains in another. The overall effect is that you moderate the volatility and smooth out your investment returns over time.

3. Across investment styles

Different investment managers adopt different styles like ‘value’ or ‘growth’, and like asset classes, these styles can perform differently at different times.

To explain these styles we’ll use a shopping analogy. Buying the largest cereal packets in a two-for-one deal at the supermarket would make you a value manager. By contrast, buying your children clothes during the end of year sales which are too big, but they’ll eventually grow into, would make you a GARP manager (growth at a reasonable price).

Spreading your money amongst several mangers with different styles helps to smooth out any performance variations when one of them has a bad day, month or year.

Conclusion

When assessing an investment opportunity, ask yourself whether the investment will further diversify your portfolio. This approach may stop you from concentrating your funds into a single asset class and making expensive mistakes, including when shopping or renovating.

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