Do ASX share portfolios provide enough diversification?

Ah, diversification… One of the most common terms you’re likely to hear in the finance world. Almost every financial advisor,…

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Ah, diversification… One of the most common terms you’re likely to hear in the finance world. Almost every financial advisor, commentator, and drover’s dog out there will tell you that having a diversified portfolio is a good thing. You know, don’t have all your eggs in one basket and all that.

But you might hear of some investors constructing a ‘balanced’ portfolio, diversifying their S&P/ASX 200 Index (ASX: XJO) shares with other assets like fixed-interest government bonds, property, or even gold. You might have even come across the concept of the ’60/40 portfolio’ (60% shares, 40% bonds) that is popular over in the United States. So is this a ‘must-do’? Let’s check it out.

Is balance always a good thing?

Well, to understand why some investors advocate for a ‘balanced’ portfolio, you have to understand what the underlying goal is. For these investors, it’s balancing potential growth with volatility. Most of us don’t really like to see the values of our share portfolios bounce around every time there is market volatility. Most of us would prefer (even if it’s deep down) to see our portfolios rise in a perfectly linear way. But that’s not what the share market gives us, at least most of the time. Now some investors enjoy this volatility, and the opportunities to buy shares ‘on sale’ that it can bring. Others hate it, and may even panic when they see their shares drop in value.

The latter investor is what a balanced portfolio is designed to cater for. The premise is simple – expose your wealth to long-term growth assets like shares, but balance the shares out with another asset class that provides lower returns, but increased stability.

In this way, you are aiming for the best of both worlds – growth with less volatility.

Diversification isn’t always free

However, since there is no such thing as a free lunch, there is always a trade-off. You usually can’t expect a portfolio that invests in stabilising asset classes to perform as well as a portfolio that’s geared for maximum growth. It’s one, the other, or a middle road between the two.

For some investors, this might be a sound idea. If you hate the idea of seeing your portfolio lose money, or experience mental distress during periods of severe market volatility, like a crash, then perhaps diversification into different asset classes may be a good idea. There are many ASX exchange-traded funds (ETFs) that can be used for this purpose. Some include the ETFS Physical Gold ETF (ASX: GOLD), or the Vanguard Australian Fixed Interest Index ETF (ASX: VAF). But if you’re an investor who wants to maximise returns, with little regard for volatility, then there might not be any reason to look to diversify. Shares, including ASX shares, are one of the (if not the) best-performing asset classes if you take a long time horizon. The ASX 200 has beaten the long term returns of government bonds and gold since Federation, and handily so.

So like most things in life, there is no ‘right answer’ here when it comes to portfolio diversification. Only what’s best for you, your portfolio, your investing goals, and risk tolerance.

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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