2023 Money Challenge
Let's talk reducing risk - the power of diversification
Yesterday, we learnt about the power of investing to build wealth. We saw how there is risk involved in any investment: property, shares or otherwise. However, we analysed that the share market, like the property market, while experiencing short term fluctuations has over the long term always trended up.
That doesn’t mean that we shouldn’t be wary of risk when investing – instead it means that we should be sensible and make smart decisions. And that by understanding risk, and how it can be mitigated, we can be more confident in the decisions we make and maybe even improve our returns.
So today we’re going to be looking at one of the best ways of reducing risk. If compound interest is #1 when it comes to investing principles, diversification is #2!
A common way to explain diversification is ‘not holding all your eggs in one basket’. This makes sense and it’s why we recommend that beginner share investors shouldn’t be trying to pick individual stock winners (of course if this brings you joy or you have the expertise in particular industries to make calculated risk, then go for it! Just ensure you’re diversifying in other ways). The reality is that no one knows with any certainty which company is going to go up in share price tomorrow, not your uncle, not a guy with an investment newsletter, not even us as experienced investors – if they tell you they know, they’re lying!
That’s why diversification is so key, it makes it likely that if some of your investments go down, others may go up. And because we know that over time the overall sharemarket has always trended up, if we hold a broad base of shares and investments we’ll more likely catch this trend.
But of course, ‘shares’ aren’t the only type of investment and to diversify well, it’s important to invest across different types of investments or ‘assets’.
If this all sounds like it’s going to make your investment journey even more complicated -don’t fear, there’s lots of ways of investing where the diversification is managed for you (Verve Money is one example).
But it’s important to understand the principle, so let’s have a look at some of the ways to diversify and the different types of ‘assets’ or ‘asset classes’ as they are called (remember, an ‘asset class’ means the type of investment – we’re teaching you this phrase as it’s often used in investing).
The four key types of ‘asset classes’ are
1. Cash and cash equivalents (imagine this like the money you may hold in your bank).
2. Fixed income, including bonds (this is essentially like a loan, i.e. to a government, or companies, it offers typically a fixed return of interest)
3. Shares, this is essentially part ownership in a company or fund that can be traded on a stock exchange.
4. Alternatives, these are basically anything else, like property or a direct investment in a renewable energy project.
Now that we know the different types of assets, let’s think about some of the ways we can diversify:
Examples can include:
1. Investing across asset classes e.g. across cash, shares, fixed income.
2. Buying shares across different geographical locations, i.e. in Australia, the US, Asia and Europe.
3. Buying shares across different industries, i.e. healthcare, technology, agriculture.
4. Applying diversification when investing in property e.g. investing across different locations (city, regional, suburban…) or property types (commercial, residential etc)
Remember, you don’t necessarily need to do this diversification yourself, and believe it or not even investing only a few hundred dollars you can achieve incredible diversification. We’ll cover more tomorrow when we look at different ways of investing.
Thanks for sticking with us until the end of this long one. I’ve got some pretty hands on tasks today that I think are going to help you realise how much you’ve just learnt! So check them out.
1. I’m giving you the challenge of identifying the different methods of diversification that we’ve just learnt about. Take a look at the Verve Money investment list here, these are the assets that we could be investing our members’ money in at any one time. Now try and identify the different asset classes that our members are invested in. Once you identified the asset types, think through the different ways that the fund is diversified. (we’re fully transparent with how we invest so it’s a great starting point for analysis).
2. If you loved activity one, then you could also apply the concept to the investments you hold through your super fund! Find out what assets, locations, and industries your super is invested in. You’ll be able to find this info on your superfund’s website and if not you can contact them.
3. Want to read more about diversification to understand it better. This article is great.
4. We’ll give you the answer to task one in the facebook group on Monday. Please drop in tomorrow or over the weekend to let us know what you found.
Today’s word of the day is:
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Want to learn more? Verve Money is an investing app that makes it easy to start ethically investing towards your goals. Best of all, we want you to feel proud of your money knowing that 20% is invested in climate solutions.