In turn, diversification can lead to a reduction in the overall level of risk or volatility associated with your investment portfolio.
Of course, the old adage about investments also rings true in that you cannot and should not use past performance as an indicator of future performance. Which means that if you diversify, it doesn’t guarantee that you won’t have volatility and doesn’t mean you are completely protected from market risks.
Given this, is it worth diversifying your SMSF investments?
When it comes to an SMSF, the first thing you should be aware of is that it is a requirement under superannuation law that you must formulate an investment strategy for your SMSF. In doing this, the law also requires you have regard to the diversification of the SMSF’s investments. Interestingly, this doesn’t require that you ultimately diversified your investments, but best practice would encourage you to ensure that your SMSF’s trustee minutes clearly document any reasons as to the diversification approach taken.
Another way that diversification is often referred to is ensuring that you don’t have all your eggs in the one basket. To use a scenario that might arise in some SMSFs, imagine if your SMSF had a direct property investment (e.g. a rental property). Depending on the total value of investments in your SMSF, a property could constitute a significant proportion of your SMSF’s investment portfolio.
Whilst that property may have been a valid investment at the time (or could be a valid consideration now or in the future), “having regard to diversification” in the context of your SMSF could mean you have to consider what the impact of a downturn in the property market could mean (as you don’t have other investments that may offset these losses), or the impact of having to sell one asset at the wrong time in order to meet liquidity needs.
Of course, this single asset scenario is far from the norm for most SMSFs, and diversification may exist already. But what is important to consider is the different ways to view diversification. It can take a number of forms.
Ways of approaching diversification
One view around diversification is to strike the appropriate balance between growth and income-based investments. Your growth assets may be shares and managed funds, whilst your income-based investments may be simple cash accounts, term deposits, or certain managed funds that pay regular income distributions, but offer little in the way of capital growth. This allocation, whilst a form of diversification, is often focused on your attitude to risk, and how much market volatility you are prepared to accept for the expectation of future returns (usually in the form of capital growth).
A second approach to diversification, which is similar to the previous, is to take it to the next level and look at asset classes. This can then involve an allocation of investments across different investment types. Typically, these might comprise cash, fixed interest, property, shares and alternative (which could be anything that doesn’t neatly fit into one of the others).
You should also consider diversification within each of these asset classes. For example, diversification within the asset class of shares can be between Australian and international Shares, and could be between different segments of the market, such as financial, mining, retail, pharmaceutical and other stocks.
Not all investment markets move in sync, so while some markets or segments may be operating at the high end, others may be at the bottom of their cycle.
No-one, not even the experts, can accurately predict when the high and low points will be. But if you’re invested across, say, a range of different assets classes — from cash through to shares — you may not need to, because those asset classes don’t always move in the same direction at the same time.
So when one asset is rising in value, another may be falling. Diversifying across different investments helps you to smooth out overall returns. You may miss out on some ‘upside’ if you’re not fully invested in the best performing asset class, but this can be compensated for by avoiding the potential impact of having all your funds in an asset experiencing a significant downturn.
Spreading your money across multiple investment types doesn’t just help to protect your portfolio from significant market movements. It can also help to smooth out your returns from one year to the next. And when used in conjunction with using a longer term, regular funding strategy like ‘dollar cost averaging’, you may not have to focus as much on trying to pick when you believe is the ‘right’ time to buy into, or sell out of, an investment.
The bottom line is that no-one knows the future
You can help to protect your portfolio by diversifying across a range of investments rather than relying on one type of asset only.
Ultimately though, it comes down to the approach you want to take. As a concept, diversification sounds relatively simple and straight forward. But choosing which markets at the right time, and in the best way, can be challenging. Like with all SMSF matters, you don’t have to do it alone.
You should consider seeking assistance from a professional adviser who understands not only investment markets, but also takes time to understand you, your SMSF and your goals. After all, success can really only be measured by how the choices you make impact on attaining your desired outcome.
Bryan Ashenden is head of technical literacy and advocacy at BT Financial Group.