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How to not put all your eggs in one basket – the argument for diversification

In a perfect world an investor in Australia would hold a four-box portfolio of investment assets featuring Australian shares, international shares, fixed interest and cash in approximately equal measure. This provides that most important element of investment, diversification. Far too many people don’t pay enough attention to it and it’s startling to see how many retirees turn up on current affairs programs talking about how they have lost their life savings on one bad investment.

It’s one of the most important rules of investing that you should diversify into different types or classes of asset to reduce risk, but there are a few local anomalies that you should know about that might adjust your allocation slightly.

The dividend franking system in Australia is generous to retirees, in terms of paying no tax, that investors would be mad not to go overweight the Australian stocks that pay reliable fully franked dividends.

Investors with taxable income, and that includes many retirees, will appreciate the extra boost the franking gives to their overall returns. In simple terms, they would most likely turn a 6 per cent annual yield into a 8 per cent annual yield, on top of what should, in the long term, be capital gain.

So why bother with international investments? Because the top Australian listed stocks actually represent a narrow universe: the big banks, Telstra and perhaps BHP or Rio Tinto. We don’t have big technology stocks such as the Silicon Valley global giants, which incidentally have thoroughly outperformed Australian blue chips in the last few years, franking or no franking.

There’s a currency risk of course but looked at another way, if the Aussie dollar falls, investors will be glad of having assets elsewhere.

It would be worth looking at Exchange Traded Funds (ETFs) that specialise in overseas shares but which trade in Australian dollars. ETFs provide hugely useful diversification at lower cost, particularly in overseas stocks, than would be the case if you bought the shares directly.

Fixed interest investment is a hard club to get into because of the size of the investments required, often running to $500,000 in one trade.

Despite this, there are managed funds and ETFs in Australia that are big enough to deal in the sort of parcels that the fixed interest market likes to trade in. Bear in mind, the fixed interest market is bigger than the sharemarket, both here and abroad.

It’s important to keep some cash in the portfolio. Term deposit rates are very low at present, as we all know, so probably a 25 per cent weighting is excessive, but investors have to be ready to move quickly in those other areas when buying opportunities present themselves.

Most importantly, it’s also critical to take advice. All the diversification in the world is useless if the investor’s capital is invested in the wrong assets, even if they are in the right classes.

By Andrew Main 

For more detail, please see the relevant Product Disclosure Statement (PDS) for the active ETF you are interested in. This article is the opinion of the author and is not financial advice. Speak to your financial advisor or broker for more information. I’m sure they’ll be happy to help you.