The importance of diversification

Everything SMSF trustees should know about investing.

The Australian banking collapse of the late 1800s, and the GFC, serve as great examples of the fact that investment markets by their nature are unstable. There will always be times of relative stability, but there will also be times when markets get overheated and overvalued, and times when panic sets in leading to markets crashing and investments become undervalued.

Throughout history, crashes in markets have not been limited to shares. During the 1980s the Australian property also suffered a decline, althouh nothing like the sharp falls experienced in the US and European property markets during the global financial crisis.

Most of the data on crashes relate to the US and a look back in time reinforces the fact that booms and busts are a natural part of investing. Since 1825 the US stock market has had 26 crashes of more than 10 per cent and 84 years of growth that exceeded 10 per cent. This fact not only reinforces the boom and bust cycles associated with share markets, it is also reassuring to know that increases outnumber crashes almost four to one.

The secret of diversifying the investment portfolio of an SMSF is to get the balance right. Just as the information on the 10 worst market crashes shows that anyone investing in shares must prepare themselves for major drops in value, it is also important to understand that at various times each of the six major asset classes outperform each other.

It is therefore important to understand that when you have too much of your available funds invested in one asset class, such as shares, when things go wrong the damage can be catastrophic.

This need to have a balanced view of investing has been supported by many sources over the years. There is a point of view that states “more value is added to a person's wealth by getting the balance right between the different asset classes than is added by investment selection”.

In other words by deciding on what percentage you allocate to each asset class, and regularly re-balancing your portfolio, you will add greater value than trying to pick what is going to be the next best share to invest in or who is the best fund manager to invest with.

 

Want access to our latest research and new buy ideas?

Start a free 15 day trial and gain access to our research, recommendations and market-beating model portfolios.

Sign up for free

Join the Conversation...

There are comments posted so far.

If you'd like to join this conversation, please login or sign up here

Related Articles