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    How to construct a diversified portfolio

    Many investors make the mistake of putting all their financial eggs in one basket. If anything goes wrong with that one product or asset they are in serious trouble. That’s why, as their savings increase, they should diversify or widen out the type of their holdings into different asset classes. Constructing a diversified portfolio is important. In this article, we cover the basic elements to consider when constructing a diversified portfolio.

    The Asset Classes

    The main asset classes for Australians are domestic equities, international equities, cash and fixed interest.

    In Australia the dividend imputation system greatly favours dividend paying locally based shares, because of the tax benefits. A  6 per cent fully franked dividend can easily become an 8 per cent return for some categories of taxpayer. That’s why for the last few years there has been a push to own the big banks, Telstra and the big miners. A problem with that is that some of those stocks have hit a sticky patch and their yield is dwarfed by the more recent drop in the shares’ value.

    There are subsets of each asset class, too. There are for instance growth stocks and value stocks. The former, such as CSL, have done extremely well over the years. The scramble by investors to get on board has pushed prices to levels that some analysts feel are too high. Value stocks are so called because they are relatively cheap by comparison. A good analyst can usually name a number of stocks that have fallen out of favour with investors to an extent that undervalues them.

    International investments, meanwhile, make a lot of sense as the technology sector is poorly represented in the universe of Australian stocks.

    It’s more expensive to trade in international stocks individually. There are a number of global ETFs (exchange traded funds) that offer access to a bundle of stocks for relatively low cost. There are also specialised ETFs focusing on areas such as technology or health care.

    Everyone needs a cash buffer but it’s best to keep it to a maximum of 20 percent of the portfolio, because returns on cash seldom exceed three per cent a year.

    Fixed interest, also known as bonds, is an asset class usually dominated by big institutional investors. Retail investors can get access by contacting organisations such as FIIG Securities. They buy up big parcels of bonds and slice them up into retail-sized slices.

    But as global interest rates rise, bond prices will go down so it may be better for investors to keep their financial powder dry rather than risk buying into an assets of declining value. The only exception to that might be Floating Rate Notes (FRNs) whose yields are usually a margin over official interest rates, so their prices don’t drop. Again, some specialised ETFs and managed funds can offer retail investors access to such assets.

    This article is part of our investing starter series. You can read more of this series here.

    These are the views of the author, Andrew Main. This is general in nature and does not take into account your personal circumstances.