Is your SMSF really diversified?
A truly diversified self-managed super fund (SMSF) investment portfolio holds a mix of different assets across multiple asset classes, in varying weightings, which behave differently in different market conditions.
For example, a fund that holds shares in each of the big four banks is not truly diversified as these investments will likely be impacted by similar sets of events and market conditions.
A better example of diversification is holding individual investments across global and Australian equities, property, bonds, fixed interest and cash.
Alternative investments can also provide diversification benefits. These include managed futures, hedge fund strategies and private equity investments, as well as infrastructure. These individually have very different risk return profiles and it’s essential to understand what these are before investing.
“It’s important to note diversification isn't as simple as investing in one asset in each class, you need to diversify within asset classes,” Pete Pennicott, a director and financial adviser with financial advice firm Pekada explains.
In simple terms true diversification is achieved where you have diversified your investments across asset classes, in holdings within each asset class and geographically across different countries and currencies, as well as investment timeframes.
Why is diversification important?
The structure of your portfolio is vitally important to ensure it can survive and cushion the severity of your losses during market dips or where you have made a poor investment selection, and diversification is a cornerstone of this.
“Without being able to predict a certain future in investment markets, diversification increases your chance of success by reducing overall risk and volatility across your combined portfolio,” says Pennicott.
“By not placing too much pressure on individual investments to provide returns you increase your margin of safety, as invariably it is very difficult for even a professional investor to have a total success rate,” he adds.
How do you achieve it?
To achieve diversification, start with understanding your risk profile, as this will provide a useful benchmark for how to allocate your investments across the different asset classes according to your appetite for risk.
Says Pennicott: “From there, applying diversification to your portfolio can be achieved through a variety of solutions from the simple to the complex. It comes down to how much control and transparency you want to have over your portfolio.”
He suggests separating your funds into different investment buckets, each with their own exposure, risks and characteristics. “By filling each bucket with the appropriate weighting of assets it gives you a far greater chance of achieving true diversification.”
What are some common mistakes people make around diversification?
The most common mistakes for investors around diversification are either overdoing or under doing it.
“Too much of a good thing is also true with diversification, as if you take the principle too far you can end up diluting your conviction to each investment to a point where you negatively impact your returns,” says Pennicott.
He explains too much diversification can result in additional complexity due to the volume of investments and subsequently increase costs without adding any value to the diversification benefits.
Says Pennicott: “On the flip side, not having enough diversification increases your concentration risk and can be a case of all or nothing. Relying on too few different investments means your fortunes are tied to a very limited number of assets and outcomes.”
Another common mistake SMSF trustees make is thinking the fund is diversified when it’s not.
“Just by having a list of different investments in your portfolio doesn’t necessarily mean you are diversified, if the underlying investments and market conditions which influence the investments are similar,” he notes.
A common example is where an investor holds several different Australian share funds, which on paper look like they are diversified. But once you lift the hood and look at the detail of the underlying investments you see that they are very similar and therefore not diversified in real terms.
No two investors are the same and so before you jump into an investment you should always put the time in initially to understand and articulate your investment preferences and risk profile.
As Pennicott notes, without knowing your risk profile, you cannot be in a position to design the appropriate weightings to different investments to diversify your portfolio.
“Once you have clear objectives the asset allocation and investment selection decisions become easier as you have a clear framework to make decisions in,” he says.