Portfolio diversification: greater returns and less risk

We have all heard of the saying, “Don’t put all your eggs in one basket.” Diversification is an essential tool of the knowledgeable and experienced investor, especially when considering investing in start-up businesses.

 

But what about the rest of us?A study conducted by ASIC showed that whilst most (78%) Australian investors had heard the term “diversification”, around half held only one type of investment, predominantly shares.

 

This lack of diversification within the portfolios of Australian investors does not only lead to greater risk, but also smaller returns.

 

Without diversification within the particularly risky startup space, investors can set themselves up for failure.

 

Top 5 things you should know about diversification:It simply means not putting your money in a single investment, asset class or business.

 

It depends on how much money you want to invest, how long you want to invest it for and how much risk you are willing to tolerate.

 

It can shield you from risks that arise from the correlations of assets, with particular risks being financial market events, such as the GFC, and industry specific meltdowns.

 

It leaves you less exposed if a business you invested in fails – you won’t lose all your money.It will help you achieve more consistent returns over time.

 

Let’s consider diversification in a startup space. It is common knowledge that the returns of startup investments are highly skewed, as more than 50% of start-ups fail, success is attributed to those few that succeed.

 

Approximately 90% of the returns in a diversified portfolio come from 10% of the start-ups. Consequently, if you invest in one start-up and it fails, you lose all your money invested.

 

Spreading your investment, and hence your risk, across different start-ups means that you are less likely to suffer a big loss if one of the business fails and are more likely to get a higher overall return.

 

While there are no current studies that capture the effects of diversification within the start-up space in Australia, the Kauffman Institute in the US found that the internal rate of return of a start-up investor is 27% per annum, given that the portfolio is adequately diversified.

 

Given the high-risk nature of start-up investment, diversification offers both a shield again hefty losses and an opportunity to earn a high return.

 

As a platform that enables diversification, equity crowdfunding makes it easy for investors to diversify within high-growth start-ups.

 

By offering a number of start-up businesses, investors are given the opportunity to discover and select the start-ups they want to place into their portfolio and become a part of. Giving investors the flexibility of choice is key, as it enables them to pick start-ups that best suit their investment horizon.

 

In addition, equity crowdfunding platforms offer the extended benefit of providing Australians with an avenue to support and engage in the growing start-up community.

 

Given that on average Australian investors own poorly diversified portfolios, it is vital to increase the emphasis on diversification. Providing investors with opportunities that allow for and encourage diversification is key.

 

As the nature of equity crowdfunding sites will prompt investors to build a diversified portfolio, the crowdfunding space will grow stronger as an investment avenue.

 

Chris Gilbert is the co-founder at Equitise, an equity crowdfunding platform launching shortly in both Australia and New Zealand.

 

For more information please go to www.equitise.com.au.