As previously discussed, investments can be broken down into the three main groups; Shares, Property and Cash.
"Diversification" means spreading your assets across these three different investments so that you don't lose too much if any one investment goes wrong.
"Asset allocation" means how you divide your assets among the three main investment alternatives, to ensure that you have the right risk reward structure to suit you.
Think of diversification this way, if you only hold 5 investments and one goes bad you suffer a 20% loss of capital. If you hold 20 investments and one goes bad you suffer a 5% loss of capital. Diversification is about limiting your losses when things go wrong.
One of the most popular investments in Australia is a rental property, to diversify a property portfolio you would need to own several properties in different cities across the country. If you are only exposed to one town a down turn in that town could wipe out your entire investment portfolio. Rental property investors with a small amount of capital can best achieve diversification through the use of a property trust.
Once you’ve decided what portion of your assets should be devoted to shares, you should make sure your share portfolio is diversified.
Diversification in a share portfolio is ensuring you are in a number of different shares in different sectors. A good example is buying bank shares, if you only hold all of the big four banks being Commonwealth, National Australia, ANZ and Westpac you are not diversified. Yes each bank has individual risk but there is also risk for the banking sector.
When the Global Financial Crisis hit, all banks fell in value. To reduce your risk your share portfolio should also hold investments in different sectors such as the Energy, Material, Consumer, Health, IT and Retail.
Your aim is to own companies in different industries in different markets, both in Australia and internationally.
Do not over diversify!
As a rule of thumb around 20 different shares is a good level of diversification, remember you are buying these shares because you expect to see capital growth and solid income. Over diversification can reduce you overall capital growth. Holding 40 different shares will not reduce your risk twice as much as holding 20 shares.
How should you divide your investments among shares, property, and cash deposits?
The appropriate asset allocation for you depends on your age, your health, your income, when you expect to retire, how many dependents you have, and many other factors. A good financial planner’s main job is to find what asset allocation suits you best.
It is important that the big structural decisions are made before investments are selected. Work out if you should invest, in your own name, that of your spouse, in your super fund, your family trust, your company. Getting the structure right, will save tax and fees, over the long run.
Shares and property are growth assets while cash is a defensive asset; you need to allocate you funds accordingly. Before you start picking the investment first determine how much is to be allocated into each investment type.
Start with cash, determine what your immediate cash needs will be over the next two years. It’s too risky to invest in shares for such a short a time, you could be forced to realise a loss if sell after a short period.
Remember though that your growth assets will also produce income so factor in this income stream.
Do not fall into the trap of holding cash “just in case”. Most sensible assets can be turned into cash on short notice. If you sell shares or listed property trusts, for instance, your proceeds are paid to you three days later.
Once you get the structure and the allocation right, you can move on to the task of selecting specific assets. I think this part is the most fun, but I promise you that asset allocation matters at least as much as your specific investments, and in many cases it matters more.