Sectors, geographies, asset classes: are you sufficiently diversified? Totality's step-by-step guide

Diversification—spreading your risks across various asset classes, sectors, and geographies—is a key tenet of investing. While the concept is well known, many Australian investors struggle with practically applying this strategy. 

Totality has produced a practical, step-by-step guide to diversify your portfolio—the only “free lunch” in investing. 

Assessing your current diversification 

To determine how diversified you are, consider these steps. 

Gather all your investment information 

1. Consolidate accounts: Start by listing all your investment accounts, including brokerage accounts, retirement accounts (i.e., superannuation), savings accounts, and any other financial holdings for a full picture of your portfolio. 

2. Include all assets: Make sure to include stocks, bonds, mutual funds, ETFs, real estate, and alternative investments like commodities or cryptocurrencies. 

Categorise your investments 

1. Asset classes: Divide your investments into major asset classes such as equities, fixed income (bonds), real estate, commodities, and cash or cash equivalents. 

2. Sectors: Within your equity holdings, categorise stocks by industry sectors (e.g., technology, healthcare, financials etc.). 

3. Geographical exposure: Identify the regions in which your investments are concentrated. If they are mostly in one region, such as the US or Australia, you may want to think about adding more international exposure. 

It is also important to understand the balance of your exposure between dividend-paying and non-dividend-paying stocks, as well as the breakdown of your growth stocks versus value stocks. Growth stocks often do not pay dividends but offer higher capital appreciation potential and generally carry higher risk. In contrast, value stocks tend to be more stable and may pay dividends, providing a balance of income and growth. 

You should then determine what percentage of your total portfolio is allocated to each asset class, sector, and geographical region—i.e., your asset allocation. 

Analyse your risk exposure 

1. ‍Concentration risk: Identify areas where you might be overexposed to a single stock, sector, or region. 

• Sectors: Look for sector concentration by reviewing how much of your equity portfolio is in specific industries. For instance, if more than 30% of your portfolio is in tech stocks, you may want to consider diversifying into other sectors like healthcare or energy. 

• Asset classes: Consider whether your portfolio is too heavily weighted in stocks and lacks exposure to other asset classes, such as bonds or real estate. 

• Geographical: If your investments are primarily in one region, such as the US or Australia, you may be exposed to country-specific risks. 

2. ‍Risk tolerance: Compare your current allocation with your risk tolerance. If you are not comfortable with the level of risk, you could consider reallocating to more conservative investments like bonds or stable dividend-paying stocks. 

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Identify diversification gaps 

1. Sector gaps: Consider whether you are too concentrated in one or a few sectors. For instance, if more than 30% of your portfolio is in one industry, it may be worth considering exposure to other sectors like financials or energy to balance out potential risks. 

2. Asset class gaps: Look at whether you are lacking exposure to certain asset classes. For example, if you primarily hold stocks, you might consider adding bonds, real estate, or commodities for a more balanced portfolio. 

3. Geographical gaps: If your portfolio is heavily concentrated in one region, like the US or Australia, international investments could help you diversify your geographical risk and benefit from global growth trends. 

Now that you have categorised your investments and gained insight into your asset allocation, sector exposure, and geographical focus, it is time to address diversification gaps. Below, we outline actionable strategies to effectively enhance your portfolio’s diversification. 

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Adopt a “Core-Satellite” approach 

The Core-Satellite approach is an investment strategy that combines passive, low-cost investments as the “core” with more targeted, higher-risk, actively managed investments as “satellites”. The goal is to achieve long-term, stable growth with the core while using satellites to pursue higher returns through active management and more focused strategies. 

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Core portfolio 

This is the stable foundation of your portfolio, typically consisting of low-cost index funds or ETFs that track broad market indices across multiple sectors, asset classes and regions. The goal is to provide steady, long-term growth with lower volatility. Examples include S&P 500 ETFs, Total International Stock Index ETFs, and Global Bond ETFs. 

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Satellite portfolio 

These are smaller, actively managed positions that focus on specific sectors, themes, or high-growth opportunities. Satellites are meant to enhance overall returns and take advantage of market trends without excessively increasing portfolio risk. 

• Sector-specific ETFs: You might consider technology, healthcare, or energy sector ETFs if you believe certain industries are poised for growth. 

• Emerging Markets: Investing in Emerging Markets provides exposure to fast-growing economies, albeit with higher risk. 

• Thematic investments: Consider themes like clean energy, artificial intelligence, or ESG (Environmental, Social, and Governance) investing for added focus. 

• Alternative assets: You might also look into commodities or real estate, either through direct investment or through REITs and ETFs. 

This balanced approach ensures the majority of your portfolio remains stable and aligned with long-term market growth, while the satellite investments offer the potential for outperformance without significantly increasing risk. 

Typically, the core investments should make up around 60-80% of your portfolio, while satellite investments should make up the remaining 20-40%. This will depend on your risk tolerance. 

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Diversify across asset classes 

To achieve well-rounded diversification, you may want to consider spreading your investments across multiple asset classes. 

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Equities 

Ensure you have a mix of large-cap, mid-cap, and small-cap stocks, and consider adding international stocks from both developed and emerging markets. 

Fixed income 

Bonds can provide stability. You may want to explore options such as government bonds, corporate bonds, and bonds with different durations and credit qualities. 

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Real estate 

Real estate investment can offer a hedge against inflation and diversification beyond traditional assets. You might consider REITs or direct real estate investments. 

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Commodities 

Gold, silver, or oil may provide diversification, and you could explore these through commodity ETFs. 

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Alternatives 

Depending on your risk tolerance, private equity, hedge funds, or cryptocurrencies could be considered as part of your alternative asset strategy. 

Sector diversification 

To mitigate sector-specific risks and capture growth across various industries, consider diversifying your investments across different sectors. This can help you reduce the impact of industry-specific downturns and potentially capture growth in various segments of the economy. This could include the technology, healthcare, energy, financials, consumer discretionary, utilities, and industrials sectors. 

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Geographical diversification 

Spread risk and potentially enhance returns by investing across different global regions, and across developed markets, emerging markets, frontier markets, regionally-focused funds, and globally-focused funds. 

By incorporating investments from different geographic regions, you can reduce your portfolio’s exposure to any single country's economic conditions and benefit from diverse growth opportunities. 

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Consider dollar-cost averaging (DCA) 

Rather than investing a large sum at once, dollar-cost averaging involves investing a fixed amount of money at regular intervals. This approach can help smooth out the impact of market volatility and enable you to build a diversified portfolio over time. Setting up automatic contributions to your investment accounts may be considered to ensure consistent and disciplined investing. 

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Regular rebalancing 

Over time, some of your investments will grow faster than others, potentially leading to an unbalanced portfolio compared to your target allocation. Consider rebalancing periodically to ensure your portfolio stays aligned with your desired asset allocation. 

• Periodic review: Review your portfolio quarterly or annually to check if any asset class or sector has deviated significantly from your target allocation. 

• Buy and sell: Sell a portion of overperforming assets and use the proceeds to buy underperforming ones to bring your portfolio into balance. 

• Rebalance with contributions: Instead of selling, you can rebalance by directing new contributions to underweight areas of your portfolio. 

Major life events like marriage, buying a home, or retirement can also significantly impact your financial goals and risk tolerance. Review your portfolio after these events to ensure your diversification strategy aligns with your new circumstances. 

By considering these strategies and regularly reviewing your investments, you can maintain a diversified portfolio that balances risk and opportunity, aligned with your financial goals.