What is diversification?

Diversification is when you mix different asset classes into your portfolio to manage your investment risk.

• Different asset classes have different expected investment returns and risks.
• Using these characteristics, managed fund portfolio managers can design their portfolio with very specific investment return expectations and risk features.
• Growth assets include equities and property.
• Defensive assets include fixed interest and cash.

Diversification is one of the most overused and least understood concepts in investing. At its most simple, diversification is about creating a portfolio of different asset classes in order to reduce the overall investment risk of the portfolio while still maximising the chance of achieving reasonable investment returns over the medium and longer term.

The principle behind diversification is that different asset classes have different expected investment returns over the medium and longer term, offset by different expected investment risks.

By mixing asset classes together, investors, or a managed fund's investment manager, are able to assemble a portfolio that they believe will suit likely future economic conditions.

For example, over the longer term, equities achieve higher average returns, but this comes with high levels of investment risk, while fixed income assets achieve lower long-term average returns, but with lower investment risk. Property achieves long-term returns midway between equities and fixed income, with mid-range investment risk. Cash, on the other hand, will achieve low long-term returns, but comes with very low or even
negligible investment risk.

By mixing equities, property, fixed-income bonds and cash into one portfolio, in years when equities and property perform strongly the overall portfolio will still perform reasonably well, but in years when they underperform the returns are offset by the more stable performance of the fixed-income assets and cash.

Diversification is improved when asset classes and the specific securities the managed fund invests into do not move in the same direction at the same time, for example when equities go down in value, fixed income assets should still go up in value. By combining assets with different performance behaviours, investors are able to achieve their goals with a smoother ride because the overall portfolio has lower investment risk.

By mixing asset classes in certain proportions a managed fund's investment managers are able to design their portfolio with particular investment return and risk expectations to suit the risk appetite or tolerance of their investors. This can be achieved to quite a precise level of likelihood by adding or subtracting specific asset classes in predetermined proportions.

These expected investment returns and risks are shown in the graph below.

Different asset classes suit different economic conditions

Another way to view portfolio diversification is that each asset class thrives in different financial and economic environments. As the environment changes different asset classes perform better or worse.

The following is a brief example of how this works. Say the economy is going through a strong and sustained period of growth due to low interest rates, that is, it is very cheap to borrow money. This growth allows  companies to raise prices, increase sales and make higher profits. This leads to higher prices for their shares.

Companies start competing for office space as they make more things, hire more people, and sell more goods. The increased demand for property means landlords can raise their rents, making their properties more valuable. Cash and fixed income, however, have  low returns due to the low interest rates.

Later on, the central bank becomes concerned about rising inflation because of higher wages and higher prices. It tries to cool the economy by increasing interest rates. Cash becomes more attractive. Initially, fixed interest might have negative returns as yields rise and the value of existing bonds decreases. As the prospect for future profits reduces, share prices fall. As interest rates hit a peak, bonds become more attractive. Later, when interest rates fall, bond prices rise.

This illustrates how asset classes behave in different ways as the economy moves through different cycles. Since it can be difficult to predict asset prices in the short term, holding a diversified portfolio of assets remains the best way of smoothing returns over any time period. All countries go through  these economic cycles and most asset classes have periods of negative returns.

Investment returns in each major asset class - December 2021

What are growth and defensive assets?

Growth assets

Growth assets are those that are expected to grow in value over time. The reason their value grows is that the income they produce (usually in the form of profits and dividends) also grows. Investors know that an asset that produces a growing income is worth more to them than an asset that produces an income that doesn't change.

The downside is that growth assets have more investment risks, that is, their value can fluctuate or even go down. Asset classes with these characteristics include equities, property and some alternatives like private equity and some hedge funds.

Defensive assets

Defensive assets, also called income assets, are those that are expected to hold their value regardless of economic conditions and deliver investment income. For this reason, they play a protective role in investment portfolios, particularly as a hedge against inflation. As a result, they are considered to be more conservative or moderate in style than growth assets.

Defensive assets have lower investment risk than growth assets, that is, they have a very low risk of losing value. However, they are expected to achieve much lower long-term rates of investment return than growth assets.
Assets with these characteristics include bonds, cash and infrastructure.

Asset classes and their expected investment returns and risks as at December 2021

Source: Rainmaker Information