By John Nunan 10 May 2016

Essential steps to diversified success (ASX newsletter)

John Nunan considers the essential steps to build a diversified portfolio.

Snapshot

  • Constructing a diversified portfolio is a personal process that considers your objectives, current investments and desired level of ongoing involvement
  • It is important to make sensible investment decisions across different asset classes

This article was originally published for the ASX Investor Update Newsletter.

One of the key principles of good investing is diversificationThe process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. . Put simply, diversificationThe process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. means not putting all your eggs in one basket. Spreading your investments across different assets helps to smooth out your overall returns, while ensuring you’re not overly exposed to any single investment or asset class.

More than just buying a few managed funds or shares, constructing a diversified portfolio'Diversification' is the process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. A portfolio with a good level of diversification is said to be a 'diversified portfolio'. is a personal process that takes into consideration your objectives, current investments and desired level of ongoing involvement.

You need to know what you’re trying to achieve before you set out to construct a diversified portfolio'Diversification' is the process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. A portfolio with a good level of diversification is said to be a 'diversified portfolio'.. For example, are you building a portfolio for your retirement in 30 years or to fund your kids’ private schooling in five years’ time?

You also need to work out your timeframe, what sort of return you’re chasing and the degree of certainty you require. ASIC’s Moneysmart Retirement Planner is a useful tool when building a retirement portfolio as you can see how your potential income, time to retirement and level of risk impact your projected final balance.

If you want to earn say 8 per cent annually to achieve your financial goals, it’s important to understand how well this aggressive strategy fits your personal psychology. If you can tolerate a fair amount of market volatilityVolatility measures the rate of change of an asset’s price and is a term usually associated with shares. The higher the rate of volatility, the more a share price ‘bounces around’ in the short term., you’re likely to be reasonably comfortable. However, if a drop in asset prices is likely to leave you nervously eyeing your portfolio (and perhaps selling) you’ll need to tread a more conservative path and sacrifice some potential return.

Your return objectives and time horizons help determine the types of asset classes you invest in since, over shorter time periods, the returns from growth assets (like shares and property) are far less reliable.

For this reason, a portfolio to fund private school fees five years from now is best built with a lower return objective (and more certainty) in mind. In this case, an asset allocationThe way you spread your portfolio among different types of investments (asset classes). For example, if you had $10,000 to invest you might decide on an asset allocation consisting of 50% term deposits and 50% shares. heavily weighted to cash and fixed interest with perhaps a small weighting to shares could be the way to go (see example in Chart 1).

Alternatively, a portfolio targeting a return of 8 per cent a year over 30 years would need to be invested in higher risk assets such as shares (Australian and international), property and infrastructure (see example in Chart 2).

Asset allocationThe way you spread your portfolio among different types of investments (asset classes). For example, if you had $10,000 to invest you might decide on an asset allocation consisting of 50% term deposits and 50% shares. ‘experts’ make it sound scientific (and complicated) but when it comes to asset allocationThe way you spread your portfolio among different types of investments (asset classes). For example, if you had $10,000 to invest you might decide on an asset allocation consisting of 50% term deposits and 50% shares. it’s important to make sensible investment decisions across different asset classes, rather than worrying if 70 or 75 per cent is the ‘correct’ allocation to shares. You need to ensure that the success of the investments and asset classes you invest in is driven by a variety of factors, reducing the overall risk in your portfolio and increasing the likelihood that your good investing will ultimately be rewarded.

You rarely start investing with a clean sheet of paper – you’re likely to already have some investments, you may own your house and have a mortgage and you are likely to have a job. You need to build a diversified portfolio'Diversification' is the process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. A portfolio with a good level of diversification is said to be a 'diversified portfolio'. around what’s already in place.

If you only own stocks in the S&P/ASX 20, you should be working out how to get exposure to international shares, small caps and other asset classes as a priority. Similarly, if you work within the banking sector and your income (an often unrecognised part of a portfolio) is linked to its success, invest less (or none) in the Australian banking sector – you have enough at risk there as it is.

When you’re ready to start building a diversified portfolio'Diversification' is the process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. A portfolio with a good level of diversification is said to be a 'diversified portfolio'., you need to honestly assess how willing you are to allocate sufficient time to do it properly. Normally the time you have available, your skill set and portfolio balance will determine if you invest directly in shares, bonds and property or if you take a managed fund approach.

Even if investing is your passion, it’s still important to be realistic. Few people have both the time and experience to cover the entire spectrum of investment opportunities, and trying to do it all yourself is fraught with danger.

A specialist fund manager like Platinum Asset Management has 28 investment professionals. Can you honestly replicate what they are doing yourself? A $50,000 investment in Platinum International Fund sees them travelling the world, meeting companies and buying international shares for you for around $750 in fees per annum – that’s a fraction of what it would cost you to do the work.

Maybe you want to manage the Australian large-cap part of your portfolio yourself and use managed funds to invest in the other asset classes. Alternatively, you might decide to use managed funds for your entire portfolio. There is no one right solution – it depends more on your skill set, time commitment and portfolio balance.

Building a diversified portfolio'Diversification' is the process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. A portfolio with a good level of diversification is said to be a 'diversified portfolio'. is more than just owning ten Australian and international shares – it is investing across and within each of the key asset classes. It means owning shares across different countries, sectors (for example, healthcare, mining, banks etc), and both large and small companies. In the context of fixed interest, it means owning bonds issued by different governments and companies around the world with varying levels of risk.

The good news is we’re spoilt for choice. There are direct shares, managed funds (either directly or through mFund), exchange traded funds, exchange traded managed funds, and listed investment companiesA listed investment company (LIC) is a pooled investment vehicle, similar to a managed fund. The main differences are that a LIC is a company (not a trust) and it's listed on the ASX. See our article on LICs for more information..

Each option has its pros and cons, but if you favour a managed fund approach even investing in a few funds – say a fixed interest fund, two Australian and two international share funds – will see you end up holding quite a diversified portfolio'Diversification' is the process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. A portfolio with a good level of diversification is said to be a 'diversified portfolio'. given the number of underlying investments these funds typically own (see example in Table 1). Ideally though you’d aim to add a few more funds – including some property and infrastructure – to this mix.

It’s important to take a patient approach to achieving your ultimate diversified portfolio'Diversification' is the process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. A portfolio with a good level of diversification is said to be a 'diversified portfolio'.. Immediately selling down your current portfolio to achieve greater diversificationThe process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. may not make sense from an investment or tax perspective, not to mention the transaction costs incurred. Instead, consider building around your current holdings - that is, deploy any new surplus cash (either from savings or sales of other investments) into desired investments.

However, keep in mind that valuations matter. If some of the investments you own look over-valued and there’s been a significant sell-off within a sector or individual asset class you’d like exposure to, it may make sense to trade.

Once established, maintaining the right level of diversificationThe process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. is crucial and this is best done by rebalancing when necessary. This can be done by investing new cash into the underweight asset classes or by partially selling down investments that are overweight.

Remember, there’s no definitive right answer to building a diversified portfolio'Diversification' is the process of spreading your investments among a range of different asset classes and individual investments with a view to minimising the impact of individual risks. A portfolio with a good level of diversification is said to be a 'diversified portfolio'. no matter how precise some financial models might look. Building your own portfolio is a personal matter and ultimately depends on what you’re trying to achieve and your current portfolio (even if the only current investment is your job!). 

This article is general in nature and does not take your personal situation into consideration. This article is not a recommendation of any investment or facility mentioned in it, and you should seek financial or legal advice specific to your situation before making any financial and/or investment decision. This disclaimer is in addition to our standard Terms and Conditions.

Disclosure: The author owns units in Platinum International Fund