Diversification: Finance's only free lunch

While the days of the 60/40 stocks to bonds portfolio may seem dated, the stock market’s roaring decade of dominance has come to an abrupt halt for now. Self-managed super fund portfolios with over-exposure to tech and growth stocks may have enjoyed a period in the sun but the past year hasn’t been so kind. A diversified portfolio is proving its importance now more than ever. 

A self-managed super fund gives owners the flexibility to invest in so much more than just stocks and bonds. Crypto, real estate and really any alternative asset class can sit beside the S&P 500 and treasuries in the modern super portfolio, a definite advancement from the portfolios constructed back when Gordon Gekko’s Wall St aired.

We look deeper into the world of diversification beyond just a textbook definition.

A free lunch

They say there’s no such thing as a free lunch in markets. Everything comes at a cost; there is no gain in potential returns without an increase in risk. Diversification may be the only instance in finance where that’s not the case, although it should be noted that all investments carry some level of risk.

Fear not, we’re not going back to first-year university finance. We’ll leave the econometrics aside but let’s explain the concept.

Diversification is the allocation of a portfolio across multiple asset classes and multiple different assets within each class. For example, owning a mix of tech stocks and bank stocks within a share portfolio but also government bonds as well.

Diversification smooths the natural ups and downs of markets. For example, if the stock market dips, a portfolio diversified across real estate, fixed income (bonds) or even crypto will have a less extreme fall than a concentrated stock portfolio. Moreover, a diversified portfolio provides exposure to the market’s ups as well. The recent property boom and stock market rally were also captured in a diversified portfolio.

This is probably obvious to most readers.

Now, back to that free lunch.  There are instances where increased diversification can increase your expected returns without changing the risk involved in your portfolio. The decreased risk associated with diversification doesn’t always have to come with a decrease in potential returns.

This is known as the Efficient Frontier in investing. Finding the right mix of assets to achieve such results is best investigated with a financial planner or adviser. 

For those interested, here are the graphs and maths used to prove the concepts.

Of course, on a simple level having multiple asset classes in a portfolio smoothes the curves between the natural highs and lows of markets.

The three buckets

Investing is a world of risk-reward ratios. Generally, conservative portfolios will sacrifice potentially higher returns for a more stable, less volatile portfolio. More balanced portfolios and growth portfolios sit further along this continuum of increasing risk while increasing expected returns. We look at three traditional industry approaches below.

Conservative: As mentioned, while the classic 60/40 stocks to bonds portfolio split may seem dated, decades of wealth were built on exposure to the relatively riskier markets and the more stable debt market. Of course, the outcomes were a lot different when US treasuries yielded more than a few percent as they did before the turn of the century. US 10 year was yielding more than 8% from the 1970s until the mid-1990s.

Conservative portfolios are those with the most limited exposure to growth assets. Generally, up to 40% of the portfolio at most will be allocated to riskier investments while the majority will be placed in defensive assets like index funds or bonds as well as a significant allocation to cash.

The most obvious benefit is capital preservation. In a market downturn, losses are smoothed out even if the longer-term upside is capped. The goal of such portfolios is just as much about lower volatility as it is capital growth. At the same time, conservative portfolios can often provide an income for investors be it through dividend payouts or bond coupons. 

Generally speaking, as self-managed super fund (SMSF) holders move towards their targeted retirement age or balance, the portfolio will move towards a more conservative balance.

Balanced: The tried and tested portfolio, a mix of growth and defensive assets to provide both income and capital appreciation while also reducing some volatility. An even mix between growth assets (U.S. shares and Australian shares) and defensive options (international and Australian fixed income) for example.

Growth: At this end of the spectrum, funds are more geared towards assets with a higher expected return. This includes higher growth stocks or a lower allocation in bonds. The most aggressive growth portfolios will sometimes have no exposure to bonds at all. Generally, younger self-managed super fund (SMSF) investors will gear their portfolios towards growth assets.

Which approach you choose to follow obviously depends on your personal situation, objectives and financial needs, which this article hasn’t taken into account. Finding the right mix may be worth doing with an expert. The ATO requires rationale behind asset allocation when constructing a self-managed super fund (SMSF) too. Largely, the Australian Taxation Office (ATO) is concerned with your strategy matching your investment goals.

The risk-reward matrix

Australian regulatory bodies have helped define the riskiness involved in different asset classes. 

Going deeper into the classification of assets into defensive and growth, asset classes are typically. 

From the lowest to the highest end of the scale we have cash, fixed income, real estate, shares, and then crypto. 

Interestingly, real estate is often classed as a growth asset but is considered low risk. 

Shares may be seen as one of the riskiest asset classes but dividend-paying bank stocks are relatively less risky than biotech stocks for example. This is important to keep in mind when constructing a self-managed super fund (SMSF) portfolio.

Of course, there are so many alternative asset classes from fine art to baseball cards. That’s the beauty of a self-managed super fund (SMSF), the investment opportunities are endless. Understanding where these assets fit into your portfolio may be best done with the help of a professional financial adviser.

Get Started

Stake Super has arrived to give you a place to construct a more diversified self-managed super fund (SMSF). 

With Stake Super, you have the freedom to invest your super in AUS & U.S. stocks and ETFs, cryptocurrency, property and a mix of alternative investments.

Learn more about Stake Super here. If you are ready to make the switch, complete our SMSF transfer form in just 60 seconds.

This does not constitute financial advice nor is it a recommendation that an SMSF may be suitable for you. As always, do your own research and consider speaking to a licensed financial adviser before making a financial decision. This article has not taken into account your personal circumstances, financial objectives or needs.