Diversification sounds good, but what does it actually mean?
Diversified investing helps us sleep at night – but the purpose of this might have been lost in translation along the way.
Let’s start by asking the question, “What are we trying to achieve here?” We want to know that if shit hits the fan, we haven’t lost everything. If we drop the basket, all our eggs have not been smashed.
What does that actually mean?
It means that when we invest, we want to build a portfolio that isn’t perfectly correlated. So let’s take an example of a change in Aussie Prime Minister – do your assets react the same way? Does your bank balance get affected by this news – nope. Does your house price get affected by this news – probably not straight away, although a change of PM could impact property markets over time. How did the Australian shares that you own within your super fund react? If you own international shares (like Facebook or Apple), did they care about ScoMo or the revolving door of Prime Ministers?
Correlation measures the way that certain things react to each other. A perfect correlation (of +1 if you want to get really nerdy), means that things are impacted in exactly the same way. Perhaps if you owned both ANZ and NAB shares, they might be pretty closely correlated with news like a government change.
A negative correlation means that when an event happens, the outcomes move in different directions. So perhaps if there was a threat of nuclear war on Australia, your bank shares might go down in value (because they’re relying on economic prosperity) but if you owned shares in a weapons company, they might go up in value. This is negative correlation (between 0 and -1 for those playing along at home). Negative correlations can be really useful when building a portfolio as it’s a way of hedging your bets, knowing if an event happen that adversely impacts your investments, at least some of your assets will go up in that scenario.
Zero correlation means there’s no connection between events. The value of your artwork is not impacted by the state of the economy. A pure zero correlation isn’t super easy to find, but things floating around the zero mark are useful in your portfolio.
A well-structured household will have money in different places so that it can be “diversified”. We want to invest in different asset classes – cash, debt, property, shares, maybe commodities, businesses, etc.
We want to invest in different regions – buying property in more than one suburb, Australian shares along with Europe, Asia, the US, emerging markets. We also want to invest for different timeframes – short, medium, long and long term so that we have access to our $$ at different points in time.
Does this mean you mean to buy 10 thousand different things? Nope. There comes a point where adding more shit to your portfolio doesn’t do a lot. We don’t want to diversify into infinity.
Diversification can take time, and money to accumulate, but it’s not out of reach. Diversification within property may take a decade or two for you to accumulate several properties in different areas.
Diversification within shares can be super easy with the rise of ETFs (exchange traded funds) which means you can instantly buy a basket of securities from day one, very cheaply.
A challenge to think about – how are you spreading the love over different asset classes, and also over different time periods? And more importantly, how does this align with your goals?
If you’re looking to get started with understanding what you’ve got and making sure it’s healthy, here’s a couple of tips to get you moving.
Understand your current position
Understanding your starting position is super important, and the best way of doing this is in a pie chart so you can see what your $$ are sitting in a really visual way.
Here’s an example of a really common asset allocation we see for new members at Wealth Enhancers.
Know how much you have available to invest
When it comes to investing, millennials will have two weapons in the arsenal:
- Cash available now
- Cash flow available over time
If your current position isn’t stacking up with how it needs to be to meet your goals and your ideal lifestyle, then deploying these two weapons will ensure you can move in the right direction.
So don’t despair if you don’t have a big pile of cash right now, you’ll have cash flow over time that you can redirect to reach your goals.
Once you know what you’ve got to invest, and you’ve got clarity on what your goals are (and therefore what your asset allocation needs to look like!) you can start to deploy those resources to get the mix right.
If all your assets are in super, and your 25, it’s going to be about building non-super assets that are flexible to reach your goals. If you’ve got mostly property (particularly if it’s your main residence), you’re likely going to be looking at Australian and international equities to insert some flexibility into your finances.
If you’re sitting on a big pile of cash, it’s going to be about deploying your resources so you get the growth you need to reach your medium and long term goals, as well as the short term stuff.
Rebalance over time
This isn’t going to happen overnight. Particularly if you’re in a pro-property portfolio, or you’ve got limited assets outside of your super, it’s going to take a number of years to get the balance right, but that’s perfectly normal.
With a lot of our members, we’re talking about a 10 to 15-year strategy to get the balance right. But it’s important to remember that the small steps you take today are critical to getting to that point in the future.
Want to know more about using diversified investments in your specific situation? BOOK IN A FREE STRATEGY SESSION!