In investment terms, “diversification” refers to the process of allocating your client's savings in a way that reduces their exposure to any one particular asset, asset class or risk. In turn, diversification can lead to a reduction in the overall level of risk or volatility associated with your clients' investment portfolios.
Of course, the old adage about investments also rings true in that you cannot and should not use past performance as an indicator of future performance. Which means that if you diversify, it doesn’t guarantee that the portfolio won’t have volatility and doesn’t mean your clients are completely protected from market risks.
Given this, is it worth diversifying your clients' SMSF investments?
When it comes to an SMSF, the first thing you should be aware of is that it is a requirement under superannuation law that you must formulate an investment strategy for your client's SMSF. In doing this, the law also requires you have regard to the diversification of the SMSF’s investments. Interestingly, this doesn’t require that you ultimately diversify your client's investments, but best practice would encourage you to ensure that your client's SMSF’s trustee minutes clearly document any reasons as to the diversification approach taken.
Another way that diversification is often referred to is ensuring that your client doesn’t have all their eggs in the one basket. To use a scenario that might arise in some SMSFs, imagine if your client's SMSF had a direct property investment (e.g. a rental property). Depending on the total value of investments in your client's SMSF, a property could constitute a significant proportion of their SMSF’s investment portfolio.
Whilst that property may have been a valid investment at the time (or could be a valid consideration now or in the future), “having regard to diversification” in the context of your client's SMSF could mean you and your client have to consider what the impact of a downturn in the property market could mean (as they don’t have other investments that may offset these losses), or the impact of having to sell one asset at the wrong time in order to meet liquidity needs.
Of course, this single asset scenario is far from the norm for most SMSFs, and diversification may exist already. But what is important to consider is the different ways to view diversification. It can take a number of forms.
Ways of approaching diversification
One view around diversification is to strike the appropriate balance between growth and income based investments. Your client's growth assets may be shares and managed funds, whilst their income based investments may be simple cash accounts, term deposits, or certain managed funds that pay regular income distributions, but offer little in the way of capital growth. This allocation, whilst a form of diversification, is often focussed on their attitude to risk, and how much market volatility they are prepared to accept for the expectation of future returns (usually in the form of capital growth).
A second approach to diversification, which is similar to the previous, is to take it to the next level and look at asset classes. This can then involve an allocation of investments across different investment types. Typically, these might comprise cash, fixed interest, property, shares and alternative (which could be anything that doesn’t neatly fit into one of the others).
You should also consider diversification within each of these asset classes. For example, diversification within the asset class of shares can be between Australian and international shares, and could be between different segments of the market, such as financial, mining, retail, pharmaceutical and other stocks.
Not all investment markets move in sync, so while some markets or segments may be operating at the high end, others may be at the bottom of their cycle.
No-one, not even the experts, can accurately predict when the high and low points will be. But if your client is invested across, say, a range of different assets classes – from cash through to shares - you may not need to, because those asset classes don’t always move in the same direction at the same time.
So when one asset is rising in value, another may be falling. Diversifying across different investments helps you to smooth out overall returns. Your client may miss out on some ‘upside’ if they're not fully invested in the best performing asset class, but this can be compensated for by avoiding the potential impact of having all their funds in an asset experiencing a significant downturn.
Spreading your money across multiple investment types doesn’t just help to protect your client's portfolio from significant market movements. It can also help to smooth out their returns from one year to the next. And when used in conjunction with using a longer term, regular funding strategy like ‘dollar cost averaging’, you may not have to focus as much on trying to pick when you believe is the ‘right’ time to buy into, or sell out of, an investment.
The bottom line is that no-one knows the future
You can help to protect your client's portfolio by diversifying across a range of investments rather than relying on one type of asset only.
Ultimately though, it comes down to the approach your client wants to take. As a concept, diversification sounds relatively simple and straight forward. But choosing which markets at the right time, and in the best way, can be challenging.
Bryan Ashenden is Head of Financial Literacy and Advocacy at BT Financial Group.
Information current as at February 2018. This information does not take into account your personal objectives, financial situation or needs and so you should consider its appropriateness, having regard to your personal objectives, financial situation and needs having regard to these factors before acting on it. This information provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such. This information may contain material provided by third parties derived from sources believed to be accurate at its issue date. While such material is published with necessary permission, no company in the Westpac Group accepts any responsibility for the accuracy or completeness of, or endorses any such material. Except where contrary to law, we intend by this notice to exclude liability for this material. Any super law considerations or comments outlined above are general statements only, based on an interpretation of the current super laws, and do not constitute legal advice. This publication has been prepared by BT Financial Group, a division of Westpac Banking Corporation ABN 33 007 457 141 AFSL & Australian credit licence 233714.