What does diversification mean?

Diversification is a term almost synonymous with investing. Most financial experts advise their clients to have a diversified portfolio. But what does diversification mean and why is it important? 

What is diversification in investment?

Investing always comes with risk. Diversification is a risk management strategy meant to balance risk by spreading it across various asset classes and investment strategies. It’s the simple concept of not putting all your eggs in one basket. 

If you buy shares in just one company and that company collapses, you might lose all your money. If, however, you have multiple investments with varying degrees of risk, your overall portfolio can make money even if individual investments lose money.

How can I diversify my portfolio?

There are a few routes you can take to diversify your investment portfolio.

Diversify by investment type

• Individual companies. These include companies such as BHP, Telstra, Woolworths, Afterpay and Wesfarmers.
• Exchange-traded funds. ETFs are funds that own a basket of securities, such as shares, bonds or commodities. So when you buy a unit in one ETF, you’re actually investing in multiple assets.
• Listed investment companies. LICs are publicly listed companies that own a basket of investments. Again, buying one unit gives you access to multiple investments.
• Real estate investment trusts. REITs are trusts that own, operate or finance income-producing properties, such as apartment buildings, cell towers, data centres, hotels, medical facilities, offices, retail centres and warehouses. So when you invest in one REIT, you’re simultaneously investing in multiple properties.

Diversify by industry 

If you invest in multiple asset classes, but those asset classes are in just one industry – such as energy or property – you might be under-diversified. That’s because if your industry of choice is affected by political or economic turmoil, your entire portfolio might suffer.

That’s why it can be a good idea to invest in multiple industries – to put your eggs in multiple baskets, in other words. That way, your overall portfolio can do well even if certain parts of it do poorly. 

Do thorough research before choosing a company or industry to invest in. Alternatively, you can save yourself the work by investing in an index fund like the ASX 200 where your money is spread across 200 of Australia’s largest public companies. 

Diversify by geography 

Investing both domestically and globally is another way to diversify. 

Why invest globally? Because if the Australian market experiences a downturn, your overall investment portfolio could still increase in value if you have overseas investments that are simultaneously doing well.

Limiting yourself to Australia means you’re putting all your eggs in the Australian basket, which may be risky. By also investing overseas, you’re spreading your risk.