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How to optimise investment risk through diversification

18 Feb 2021 by Nikko AM NZ

Investment diversification is a concept most people are familiar with, but surprisingly, often forgotten by even the savviest of investors when exciting investment opportunities arise.

Typical definitions of investment diversification focus on lowering risk by allocating money across a mix of financial sectors, industries, and categories. The premise being that each would react differently to the same market events, thereby reducing your overall exposure to loss.

However, an alternative approach to diversification is to consider how it can be used not necessarily to reduce risk but to optimise risk as it relates to your personal investment objectives.

Whether your investment portfolio is 100% in KiwiSaver funds, or a mixture of many different investment structures, you have the opportunity (and ability) to optimise your risk by carefully selecting the specific types of funds and/or assets your money is invested in.

How do you do this? There are three key factors that influence the optimum level of diversification in your portfolio to meet your objectives:

  • your timeframe
  • other investments you may have
  • your level of comfort with risk

Are your investments diversified enough? Ask yourself these three questions.

Asking yourself these simple questions will help you understand whether your KiwiSaver (or other managed funds) investments are aligned with your objectives and optimised for your circumstances.

1. What’s your timeframe?

Consider the time you have until you expect to use or withdraw your investment. For example, if you just started out in KiwiSaver and plan to make a first home withdrawal in the next year or two, your timeframe will be very different than someone in their late 40s who owns their own home, for whom KiwiSaver is a small part of their overall investment mix for their retirement. First home buyers who will soon need to access KiwiSaver for their deposit might consider looking at a more conservative mix. Once they’re in their first home, this fund mix can then be adjusted to higher risk funds with a longer investment horizon.

Depending on your timeframe, a specialised investment opportunity that carries higher potential risks and returns – such as the ARK Disruptive Innovation Fund – could have a role to play within a diversified portfolio which may include other types of investment like property, a business, local and global equities etc.

2. What other investments do you have?

This is the (financial) theory of relativity – your ability to withstand volatility based on the size of each type of investment, relative to your total assets. Let’s say your KiwiSaver is heavy on equities, and it halves in value. If you’re a multimillionaire with freehold rental properties, business and cash assets, this is a blow, but one from which you’ll recover, because it’s just one portion of your wealth. If, on the other hand, that KiwiSaver account is your main asset, it’s a much bigger setback.

If KiwiSaver is your entire retirement saving plan, you might want to make sure it's well diversified across different funds and strategies. But if it is a small portion of your total retirement plan, you may be more comfortable with a more aggressive fund. Consider how to achieve diversity with a mix of assets as you grow your wealth.

3. What’s your personal risk comfort zone?

Your level of comfort with risk is important, regardless of your timeframe and mix of investments. The personal risk element deals with the issue of choosing assets with smaller price movements due to either a preference for not having the worry of seeing things change by large amounts, or not being able to take losses.

For example, if day-to-day price movements in your investments keep you awake at night, then a diversified portfolio of assets that experience smaller price movements may be the best approach to give you a higher degree of comfort.

The flipside is that, over time, this more cautious approach is likely to (but may not necessarily) lead to lower overall returns.

From a diversification perspective, the argument still holds that diversification helps you optimise your risk and is possible to achieve even within a lower-risk group of assets. For example, if all you want to own is term deposits, having these set up with different maturities with different providers will provide you with a more optimal risk profile than having everything in one term deposit in one bank.

Rethinking your approach to risk

In general, investing in the things you’re interested in and know something about, will help you stay engaged with your portfolio and be motivated with your contributions. You don't have to be ‘all-in’ with a higher risk fund – this could be the spice that keeps your portfolio interesting, rather than the main ingredient.

Remember, diversification is a strategy to optimise, as much as lower risk. Consider the most efficient way to manage risk in line with your goals. For example, a portfolio with a very high proportion of cash, may keep you safer from losses, but is unlikely to give you the gains you want either.

Understand when you’re simply exchanging one measure of risk for another – the danger of the loss of opportunity. You’ll never make money off the investments you don't make.

Things you might want to consider:

  • Investing regularly and steadily, at an amount you can afford, across a mix of investments that are aligned with your goals, timeframe and personal comfort with risk.
  • Depending on your time horizon, you may aim to hang onto those investments for a decent period of time.
  • Focus on your long term and overall investing goals, rather than stressing about any short-term deviations that may occur.
  • If you feel comfortable, consider making subtle, incremental changes as your life changes.
  • But, if you don’t feel you have the right diversification in your investments today, it’s easy to change if you’re invested with Nikko AM.  

If this article has got you thinking about investing or changing your investment strategy, a great way to plan your investments is via the GoalsGetter tool- our smart online platform that steps you through selecting an appropriate fund to match your investment profile and goals.
 
In this article we mentioned the Nikko AM ARK KiwiSaver Disruptive Innovation Fund. You can learn more about this fund here: Learn more about this Fund

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