Diversification is a key approach for structuring any portfolio. It’s important to develop strategies and rules that govern how your portfolio is structured, or else you may be taking on a level of risk that is mismatched to your risk appetite.
What Is Asset Diversification?
Asset diversification is a strategy which encourages investment across multiple industries or asset classes. (When we say ‘asset class’, we simply mean different types of assets such as stocks, bonds, real estate and cryptocurrency.)
When an investor’s portfolio is diversified, it means that their investments cover a range of different asset classes and industries. Typically, these investments will react differently to major external events such as the outcome of an election or the signing of a bilateral trade agreement.
You’ll notice this concept of diversification is used a lot in other real-world situations.
For example, more often than not it doesn’t make much sense for a retailer to sell just one product or have just one supplier. By selling only one product, the retailer risks significantly reduced revenue if consumer interest in the product declines. Similarly, by relying on only one supplier, the retailer is fully reliant on this supplier’s ability to satisfy the retailer’s demand, if the supplier goes out of business or has production delays the retailer’s revenue could be dramatically affected. Instead, business owners reduce risk by appropriately diversifying their product lines and supply chain dependencies.
Looking into the structure of superannuation portfolios can help you grasp the concept of asset diversification. As super account holders typically have a decades-long time horizon, their portfolios will consist of a range of asset classes to ensure they are diversified. These portfolios may hold an array of precious metals (e.g. gold or silver), stocks (e.g. energy or technology stocks) and property (e.g. residential or commercial real estate).