How a Diversified Portfolio can reduce risk… and increase returns

A diversified portfolio helps reduce investment risk in two main ways:

  1. A broad range of securities lessens the impact on a portfolio of one security failing.
  2. Investments across the major asset classes tends to smooth the overall portfolio returns, because while one asset class is in a downturn other asset classes can be performing well.

A diversified portfolio also gives you access to the potentially higher returns from quality shares and property combined with the security of fixed interest and cash.

This can be seen in Chart 1 which compares the volatility and long term returns of shares versus cash versus a broadly diversified portfolio. As you can see, the latter has generated higher returns than cash with less volatility than shares.

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*Sources: 1 Jan 1982 – 1 Jan 2015. Cash: RBA cash management accounts at banks ($10,000). Term Deposits: RBA Stats Banks’ fixed deposits ($10,000). Shares: The All Industrials Accumulation Index to 31/12/01 and the S&P/ASX XNJAI thereafter. Property: The S&P/ASX 200 Property Accumulation Index. Diversified Portfolio based on 50% shares, 25% property, 5% cash, 20% term deposits. Note: Tax and fees are not taken into consideration. Income is re-invested. Past performance is not an indicator of future performance.

Case study

Let’s say you and your spouse have $100,000 to invest on 1 January 1982.

Chart 2 shows how much wealth you may have created by investing in certain assets by January 2015, assuming income was re-invested. As you can see, if you had invested your money into term deposits, it would have grown to $931,615. But if you had invested in a diversified portfolio1, you would have $3,232,447. It’s a $2,300,832 improvement.

Now let’s assume you retired at the start of 2015. What would be your investment income position? Your diversified portfolio would be generating an income of something like $144,657 this year (based on last year’s income). On this, you and your spouse could expect to pay tax of $8,684 (as shown in Table 1).

Compare that to the $31,675 net income you would receive from term deposits this year (based on last year’s income).

Table 1: Retire 1 Jan 2015 after investing $100,000 on 1 January 1982*

                                                               Diversified Portfolio         Term Deposits
Capital value                                             $3,232,447                    $931,615
Expected income
(based on last year’s yield)                         $144,657                      $31,675
Tax on income**                                        $8,684                          $0
                                                               __________                   ________
Net Income                                             $135,973                       $31,675

** Assumes income splitting with a spouse and no other assessable income for income tax calculation purposes. Shares 80% franked. Income not re-invested in retirement. Tax rates 2014/15. Portfolio based on 50% shares, 25% property, 5% cash, 20% term deposits. Past performance is not an indicator of future performance.

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