What does diversification mean for an investment portfolio?
Diversification is achieved by building an investment portfolio, which is a group of individual company shares or other securities of different investments that have different characteristics. Because of this no one particular asset dominates, for example, by size, source and size of returns, sector, volatility, geography or market capitalisation.
These different investments, with their own characteristics, might behave differently and might have different risk characteristics. For example, a a large company, like Commonwealth Bank, and a smaller mining services company, like MacPherson's. Brought together in a combined portfolio, they can lower risk and generate more stable returns than would likely be achieved holding just one of these investments on its own. This is because over the same period, some investments will perform well while others not so well. Overall, one of the most effective ways of reducing risk in an investment portfolio is to have a broad and diversified pool of assets.
The benefit of diversification is that it reduces risk
The underlying principle behind diversification is that returns from different types of investments and assets classes are affected by many factors. Spreading our investments across assets that individually behave differently to these factors generally reduces the volatility of investment returns.
The impact of investment risks can also be reduced through diversification, such as:
- counterparty risk – the risk that another party to a transaction might not meet its obligations
- event risk – the risk that an economic, political, terrorist or natural event might impact investment markets
- manager risk – the risk that an investment manager fails.
Using our default Capital Guarded investment option as an example, across the different investment options there is broad diversification across asset classes. Because of this, we’re generally able to deliver more stable, less volatile returns over the long term.
How can a portfolio of assets, such as an investment option, be diversified?
Firstly, you diversify at the broad asset class level. These asset classes include shares, property, bonds and cash.
At the next level down, you diversify within an asset class by investing in a broad range of different investments within that asset class, whether it be by geography, industry, sector or securities. For example, in the bonds asset class you could invest in high yield bonds and government bonds.
The benefit of this is that the investment option isn’t dominated by one particular group of assets. This minimises the impact of poor performance from any one group of investments, because different investments do well at different times of the economic cycle.
A further level of diversification is by ‘investment style’. This is achieved by investing in a selection of investment managers who each have a different investment style, or investment approach, for investing in a particular asset. Different investment styles interact differently with the broader economic cycle. Therefore, at any one point in time it’s not unusual for one investment style to be less effective and out of favour and others to be more effective and in favour.
What are the two major investment styles?
The two major investment styles are value and growth.
Value style – A manager will buy companies whose stock price has in their opinion somehow been incorrectly priced by the market.
Growth style – A manager will buy companies they think have potential for earnings growth. An example is an internet based business such carsales.com.au
Another investment style is a manager’s approach to the size of individual positions they take in different investments. Some managers are diversified and hold a large number of different investments. Others have ‘concentrated’ portfolios with much fewer holdings, called ‘high conviction’ or ‘concentrated’ style.
Definitions of some different investment styles
Growth investment style
A growth investment manager looks to perform better than the broader market by buying companies with potential for high earnings growth. The current price of the share is less important than how the company is expected to grow and increase profits in the future. Growth managers believe they can identify a company’s earnings growth rate into the future and that the market has underestimated the company’s current and future growth potential. As such, they're willing to pay higher prices (price to earnings or PE) or price-to-book value, for these companies.
Value investment style
A value investment manager looks to perform better than the broader market by buying companies whose stock price, in their view, has been incorrectly priced by the market, eg companies that the market has temporarily given up on or companies that have good fundamentals but which have had recent negative news the manager believes has caused a short term over-reaction by the market. These companies generally have higher dividend yields and lower PE ratios. Often value investment managers focus on what is called ‘defensive’ industries or sectors that have lower growth prospects, all things being equal.
Growth at a reasonable price investment style
Growth at a reasonable price (GARP) is a share market investment style that combines both ‘growth’ and ‘value’ investment styles. GARP investors look for companies showing consistent earnings growth above the market, the basis of growth investing, while excluding companies that have high valuations, the basis of value investing. The overarching goal of GARP is to avoid the extremes of both growth and value investing. This typically leads GARP investors to invest in growth-oriented stocks with relatively low valuations, which can be measured by an asset’s PE multiple, in normal market conditions.
Diversification and our investment options
What diversification means for the Australian Shares investment option
In the Australian Shares investment option, each investment manager is selected to bring different investment characteristics.
One common manager grouping used in the investment industry is managers that buy shares in large capitalisation companies, which are typically found in the ASX200 list of companies. Large capitalisation managers are often differentiated by being either a value or growth manager or a variation of these. Some of these managers have a more diversified portfolio of shares while others have a more concentrated portfolio.
Another common manager grouping is managers that buy shares in smaller capitalisation companies, which are typically found in the ASX 200 to 300 list of companies.
There are also investment managers who focus on companies outside the ASX300. These companies are referred to as micro caps and are generally emerging businesses. Generally, smaller companies are considered higher risk than larger, more established, companies.
Share prices can rise and fall suddenly in response to many factors, including company profit announcements, shifts in market sentiment, industry issues and broader economic trends. These risks are mitigated to some degree by having a well-diversified investment portfolio.
What diversification means for the International Shares investment option
With the International Shares investment portfolio, diversification is achieved through a mix of investment styles and by investing in companies across large, small and micro-cap sectors and geographies. Investing in a large number of individual shares increases the likelihood that a portfolio won’t experience large fluctuations in value when compared to investing across a smaller range of shares.
Another benefit of investing in a large number of individual shares is being exposed to a range of different economic sectors through investment in a range of geographical regions and countries.
What diversification means for the Balanced investment option
The Balanced investment option benefits from investment manager and portfolio diversification. It's also diversified across asset classes by investing in Australian and international shares, bonds, property, alternative assets (eg high yield corporate bonds, emerging market bonds, hedge funds, private equity and infrastructure) and cash.
These different asset classes perform differently under different market conditions and rarely perform well at the same time. Exposure to these different sources of returns helps generate more stable and consistent returns.