One of the most often used clichés in the world of investing is “not to put all your eggs in the one basket”. While it may be a well-worn cliché, it’s possibly the single most important piece of advice an investor is ever likely to receive.
But what does this old adage really mean for investors?
Rather than purchasing shares in only one company (such as a large bank or mining company), which could be considered a high risk, should you instead spread your risk by purchasing shares in several companies?
To properly diversify your investment portfolio, you should consider investing not just in several companies but also across different asset classes.
All investments fall into a particular asset class based on the type of investment, and importantly, its relationship to risk and return. These asset classes include:
Listed Australian property
Listed international property, and
Defensive asset classes
Cash and fixed interest investments are considered defensive asset classes. Cash includes term deposits and bank bills. Fixed interest includes government, semi government and corporate bonds. Westlawn Unsecured Notes are another example of fixed interest investments.
With these defensive asset classes, there is a lower risk of losing your capital when compared with other asset classes. However, you should also expect lower returns over the longer term.
Growth asset classes
Growth asset classes include Australian and international shares, listed Australian and international property and direct property. With growth assets, there is the potential for higher returns and capital growth over the longer term, but also the potential for higher volatility over the shorter term when compared with defensive assets.
As we can see, there is a direct correlation between the level of risk and potential returns from any investment. As the potential for higher returns increases, so too does the risk of increased volatility.
No such thing as a risk-free investment
Because bank term deposits are generally considered to be safe, there is a misconception that these are risk-free investments as there’s little or no risk of losing your capital. However, like all investments, there is still some risk involved when investing in cash.
If you were to invest all your money in a term deposit, the risk is that the return on your investment over the specified term may not keep pace with inflation. When you consider interest rates are now at record lows, this is especially applicable in the current environment. While you may consider your capital to be safe, the risk is that the purchasing power of your investment may diminish over time.
At the other end of the spectrum, buying shares in an international technology start up business may offer the chance of huge rewards … but you could also lose all your money.
Spreading the risk, it’s really quite simple
While spreading your investment risk across asset classes may seem complicated, it can actually be quite simple. Investing in managed funds, listed investment companies (LICs) and exchange traded funds (ETFs) can provide diversification across asset classes so that you can achieve the right balance of risk and return for your investment portfolio.
In next month’s Investment Fundamentals, we’ll look at these investment options in greater detail.
General Advice Warning The advice on this site may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. Please seek personal financial, tax and/or legal advice prior to acting on this information. Westlawn Wealth Management Pty Ltd ABN 32 124 861 409, Authorised Representatives of GWM Adviser Services Limited ABN 96 002 071 749, Australian Financial Services Licensee, 105 -153 Miller Street North Sydney NSW 2060.
 From 1 February 2012, the Federal Government’s Financial Claims Scheme guarantees certain bank deposits up to $250,000 per person per institution.