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The diversification effect

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These recent months have been a stark reminder of the volatility of share markets and the impact it can have on your life savings and your retirement.

In 2002, United States Secretary of Defense Donald Rumsfeld famously stated:

“there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.”

Put this statement in the context of the assets needed to fund your retirement. There are risks to investing that are known but uncontrollable (known unknowns); such as interest rate movements and there are risks that we can’t predict (unknown unknowns),e.g. geopolitical crises.

Diversification can assist in managing your investment risk and planning for both “known unknowns” and “unknown unknowns”; by not having all your eggs in one basket.

In a diversified portfolio, investments are spread across different asset groups and investment regions. This can assist to offset negative movements in some investments by the positive performance of other assets. This can help smooth out investment returns over the longer term providing more certainty for investors.

Here are some examples of risks and the impact of diversification:

1. Domestic bias

Australian investors generally have a high proportion of investments in Australian equities. Yet Australia represents only a small portion of the global market – around 2% of global market capitalisation (Source: World Bank, July 2013). Investing in other global economies could reduce the risk of a poor investment outcome if the Australian economy underperforms global counterparts.

2. Currency impact

The impact of fluctuations in currency can have significant impact on a portfolio. During the GFC, the US Dollar weakened relative to the Australian Dollar, however over the six months from July 2014, the Australian Dollar has fallen around 15%. Investors with exposure to US investments have benefited from this fall as the value of their investments has increased in Australian dollar terms.

3. Low protection from share market volatility

A portfolio with high exposure to a single asset class will provide below average returns if that asset class underperforms the market. This means holding investments in a variety of asset classes such as fixed interest, cash or property in comparison to predominantly equities may help smooth the returns of your overall portfolio during periods of high share market volatility.

Dixon Advisory provides advice across a breadth of asset classes including: cash, gold, income investments, property, Australian equities, international equities, in order to manage risk and preserve capital.

If you feel you have too great an exposure to a single asset class or would like to understand more about our diversification approach, please contact me on 1300 264 485.
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