You must diversify your portfolio. No doubt you’ve heard this sage advice from accountants, financial advisors, friends and family. But why is diversification so good for your investment portfolio, and what are the best ways for you to start to diversify? What’s so great about diversification anyway? The reason why diversification is so coveted by investors is that it reduces your portfolio’s exposure to different types of risk, while also increasing the number of scenarios in which you can earn a positive return. Take for example a hypothetical portfolio which consists of equally-weighted investments in an airline company, like Qantas…
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You must diversify your portfolio. No doubt you’ve heard this sage advice from accountants, financial advisors, friends and family. But why is diversification so good for your investment portfolio, and what are the best ways for you to start to diversify?
What’s so great about diversification anyway?
The reason why diversification is so coveted by investors is that it reduces your portfolio’s exposure to different types of risk, while also increasing the number of scenarios in which you can earn a positive return.
Take for example a hypothetical portfolio which consists of equally-weighted investments in an airline company, like Qantas Airways Limited (ASX: QAN), and an oil producer, like Beach Energy Ltd (ASX: BPT).
Both of these companies are heavily exposed to the price of oil, but in opposing ways. For Qantas, higher oil prices mean higher fuel costs which will in turn dampen profits.
For Beach Energy, higher oil prices mean increasing revenues and greater incentives to expand its business through new, profitable projects. But if oil prices fall the opposite holds true: Qantas increases its profit margins and Beach Energy starts thinking about winding back production.
A portfolio that consisted of an investment in either one of these companies alone would be totally exposed to oil price risk. But combine the two investments and you manage to hedge some of that risk away. When oil price fluctuations hurt one company, the other stands to benefit, meaning you offset some of your losses and the volatility of your overall portfolio declines.
And that allows you to sleep a little easier at night, knowing that your capital is protected from any unexpected bumps in the global price of oil.
What are some ways to quickly diversify your portfolio?
Well, the above example is simplistic at best. Maybe that hypothetical portfolio offers some slight protection from movements in the global oil price, but there are a myriad other risks that affect both Qantas and Beach Energy.
Qantas might be impacted by seasonal lows in tourist numbers, or threats from other global airlines – while increasingly cheap solar or wind energy might hurt the profitability of Beach Energy’s current oil and gas projects. Or these companies might simply suffer from mismanagement.
To try to hedge away these other idiosyncratic risks, you would have to continue to add more companies to your portfolio with alternative risk exposures.
So while some level of diversification is within the grasp of everyday investors, to truly diversify your portfolio can start to become very expensive, very quickly. This is especially true if you want to enjoy the diversification benefits offered by asset classes outside of equities, such as real estate.
Enter Real Estate Investment Trusts (REITs)
For most average investors, buying an office building or a shopping centre is impossible – this asset class is just simply too expensive. But real estate often exhibits different risk and return characteristics to equity investments, and can offer great diversification benefits to your portfolio – if only you could afford the hefty price tag.
Well, it turns out you can. Australian Real Estate Investment Trusts (A-REITs) are unitised portfolios of property assets which are listed on the ASX and trade just like normal shares. Buying a share in a REIT gives you access to the rental income generated from the trust’s assets.
REITs generally have to pay out at least 90% of their taxable income as dividends to investors – but some can pay over 100%, as tax deductions for expenses such as depreciation can actually mean the income the trusts have available to distribute is actually higher than their taxable income.
There are many different types of REITs, but three of the largest currently listed on the ASX are Scentre Group (ASX: SCG), which owns a portfolio of shopping centres across Australia and New Zealand, Goodman Group (ASX: GMG), which manages and develops large scale logistics facilities and business parks, and Lendlease Group (ASX: LLC), which specialises in infrastructure development.
So if you’re worried that your portfolio is overly exposed to certain types of risks you could consider investing in a REIT. These investments can allow you to quickly access the diversification benefits of a new asset class at an affordable price.
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You can find Tom on Twitter @tommyr345
The Motley Fool Australia has recommended Scentre Group. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.