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The importance of diversification

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One of the most important decisions you can make in building or maintaining your wealth is asset allocation – that is, deciding which assets to invest in and how much to invest in each asset class.

An effective investment portfolio will be diversified, investing a lot of money in one asset or with one fund manager can be very risky. The trick is to spread your money between assets classes. Historically, allocating money between Australian shares, global shares, property trusts and bonds has been effective because their risk and return characteristics have had a low correlation.

Will this strategy still work in the 21st century? What will happen if the current volatility in the Australian share market continues and becomes a long-term slow down? If the other asset classes have a low correlation to Australian shares you would expect to get reasonable returns from them. But will you?

Bonds – interest rates around the world are at historically low levels and returns of 6% are not attractive.

Global shares – as globalisation continues world economies (and hence share prices) are much more closely related. The level of correlation between share markets has increased and returns move in the same way as Australian shares.

Listed property trusts – Australian LPTs have restructured in recent years and their risk and return characteristics are very similar to Australian shares.

The search is on to find reliable fund managers investing in assets with a low correlation to traditional assets.

In the 2007 Federal Budget, Peter Costello announced an educational endowment fund. His idea is based on a successful model used by Yale University in USA. They have invested in innovative ways and over the last 15 years have earned compound returns of 17% a year. What if you could do the same?

Alternative asset classes

Possible alternatives are:

  • Private equity – company shares not listed on a stock exchange. These can be well-established companies or start-ups. Unlisted shares are less researched and a specialised manager will be able to identify likely future winners.
  • Global infrastructure – investing in assets such as roads, airports and power generation can provide a guaranteed income stream and potential capital growth.
  • Global real estate – the adoption of Real Estate Investment Trusts (REITs) – like our LPTs – in Europe and South East Asia will open opportunities for reliable long-term income streams and potential capital growth.
  • Absolute return funds – fund managers who identify opportunities to produce returns in all market conditions using a mix of traditional and innovative asset selection techniques.

Talk to your financial planner if you want your portfolio to have 'downside protection'.

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