WHAT TO OWN · LAYER 2
The Power of Diversification
Don't put all your eggs in one basket.
— Traditional Wisdom
Learn why spreading investments across different asset classes is the closest thing to a free lunch in investing.
This Page Takes: 20 minutes
Why This Matters
Diversification is the only free lunch in investing. By spreading your investments across different asset classes, you can reduce risk without sacrificing returns. Understanding how and why this works is crucial to building wealth.
What Is Diversification?
Diversification means spreading your investments across different asset classes, sectors, and geographies to reduce risk. The principle is simple: when one investment falls, others may rise or remain stable, smoothing your overall returns.
It's not just about owning "lots of things." True diversification means holding assets that don't move in lockstep — assets that respond differently to the same economic events.
Not Diversified
Owning 10 different Australian bank stocks. They all rise and fall together based on interest rates, property markets, and banking regulations.
❌ Same sector, same risks, same movements
Well Diversified
Owning Australian stocks, international stocks, property, bonds, and gold. When stocks fall, bonds and gold often rise, protecting your portfolio.
✅ Different assets, different risks, smoother returns
Understanding Correlation
Correlation measures how two investments move together. It ranges from +1 (perfect positive correlation) to -1 (perfect negative correlation), with 0 meaning no relationship.
Positive Correlation
Assets move in the same direction. When one goes up, the other goes up. When one falls, the other falls.
Example: ASX 200 and individual Australian bank stocks (correlation ~0.8-0.9)
Zero Correlation
Assets move independently. One going up or down tells you nothing about the other.
Example: Australian stocks and agricultural commodity prices
Negative Correlation
Assets move in opposite directions. When one rises, the other falls. Perfect hedge.
Example: Stocks and gold often have negative correlation during crises
The Diversification Sweet Spot
The best diversification comes from assets with low or negative correlation. You want investments that zig when others zag.
Example: During the 2008 financial crisis, Australian stocks fell 40%, but government bonds rose 15%. If you held both, your losses were much smaller than holding stocks alone.
Why Diversification Reduces Risk
It's not magic — it's mathematics. When you combine assets that don't move together, the volatility (ups and downs) of your overall portfolio decreases, while your expected long-term returns stay similar.
A Simple Example
Portfolio A: 100% Australian Stocks
- Average return: 9% per year
- Volatility: ±18% (big swings)
- Worst year: -40% (2008)
Portfolio B: 60% Stocks + 30% Bonds + 10% Gold
- Average return: 8% per year (slightly lower)
- Volatility: ±11% (much smoother)
- Worst year: -22% (2008)
Portfolio B delivered almost the same returns with 40% less volatility and half the maximum drawdown. You sleep better and stay invested longer.
Reduces Volatility
Smooths out the ups and downs. Your portfolio value is more stable month-to-month.
Maintains Returns
Long-term expected returns stay high because you still own growth assets like stocks.
Behavioral Benefit
Easier to stay invested during crashes when you're not down 50%. Discipline = wealth.
Modern Portfolio Theory (Simplified)
In 1952, Harry Markowitz won a Nobel Prize for proving mathematically that diversification reduces risk. His key insight: it's not about individual assets — it's about how they work together.
The Efficient Frontier
Imagine a graph where the X-axis is risk (volatility) and the Y-axis is expected return. Every possible portfolio sits somewhere on this graph.
The "efficient frontier" is the line connecting portfolios that offer the highest return for a given level of risk. Any portfolio below this line is inefficient — you're taking risk without being compensated with higher returns.
The lesson: By combining different asset classes strategically, you can build a portfolio on the efficient frontier — maximizing returns for your chosen risk level.
What This Means For You
You don't need a PhD to apply this. The principle is simple: don't just buy more of the same thing.
If you own 20 tech stocks, you haven't diversified — you've concentrated risk. But if you own a mix of stocks, property, bonds, and gold, you've moved closer to the efficient frontier.
Real-World Case Studies
Let's see how diversification performed during three major market events: the 2008 financial crisis, the 2020 COVID crash, and the 2022 rate rise shock.
2008: Global Financial Crisis
October 2007 – March 2009
The lesson: A 100% stock portfolio lost 40%. But a diversified portfolio (60% stocks, 30% bonds, 10% gold) lost only ~22%. That's the difference between panic-selling and staying the course.
2020: COVID-19 Crash & Recovery
February – March 2020
The lesson: The crash was sharp but short. Diversified portfolios fell less and recovered faster. Bonds provided stability, gold held firm, while stocks and Bitcoin both crashed but recovered by year-end. Even high-volatility assets like Bitcoin eventually rebounded.
2022: Interest Rate Shock
January – December 2022
The lesson: Rising rates hurt both stocks AND bonds (rare occurrence). But gold held its value, showing why diversifying across truly different assets matters. No single asset class wins every year.
Diversification Isn't Perfect
Example Diversified Portfolio
Here's a simple, well-diversified portfolio for an Australian investor in their 30s-40s.
Australian Stocks (VAS)
ASX exposure, franking credits
International Stocks (VGS)
Global diversification
Precious Metals (Gold/Silver)
GOLD, PMGOLD ETFs or physical
Mining Stocks
Gold/silver miners for leverage
Bitcoin
Digital scarcity play
Other Crypto (ETH, XRP)
Alternative blockchain exposure
Bonds (VGB, VAF)
Stability and income
Why this works: This forward-looking allocation anticipates the next 10-year cycle. Traditional stocks are near all-time highs, so allocation is reduced. Precious metals are being revalued after 50 years of suppression. Crypto offers digital scarcity as fiat currencies weaken. You have defensive assets (bonds, gold) alongside growth assets (stocks, crypto, mining).
Adjust to Your Situation
This is just one example. Younger investors might increase stocks and Bitcoin (more risk, longer time horizon). Pre-retirees might increase bonds and reduce volatility.
The key principle remains: own multiple asset classes that don't all move together.
These Are Starting Points, Not Rules
The allocations shown above are reference guides based on historical data. The wealthy don't follow static allocations — they adjust based on opportunity and market cycles.
Our Wealth Cycles Philosophy
Identify and Accumulate Undervalued Assets
When asset classes are historically cheap (low percentile rankings), consider increasing your allocation. This is when you're buying at a discount — the foundation of long-term wealth building.
Reduce Exposure to Overvalued Assets
When asset classes are historically expensive (high percentile rankings), consider reducing your allocation. Selling strength is just as important as buying weakness.
Understand Historical Context
By knowing where we are in historical cycles, you can better foresee likely market trends. Markets move in cycles — what's expensive today may be cheap tomorrow, and vice versa.
Bottom line: Use the allocations above as starting points, then adjust based on:
- • Where each asset sits in its historical cycle (see our Cycle Indicators)
- • Your own research and conviction about specific asset classes
- • Your personal risk tolerance and time horizon
- • Major economic shifts and policy changes
We educate, you decide. Your portfolio should reflect your understanding of the world, not a fixed formula.
Want to Learn More About Cycles?
Understanding wealth cycles is what separates good investors from great ones. In Layer 3 (Why It Works), we dive deep into the historical patterns, economic drivers, and timing signals that help you identify when assets are cheap or expensive.
Start Wealth Cycles Education →Advanced Strategy: Borrow, Don't Sell
Once you've built a diversified portfolio, learn how wealthy investors access liquidity without selling their assets.
In Layer 4 (How To Execute), we teach an advanced strategy used by the wealthy:
- • Borrow against your assets (Bitcoin, gold, stocks, property) to get cash
- • Avoid CGT entirely (loan proceeds aren't taxable income)
- • Keep 100% of future upside while accessing liquidity now
- • Learn the risks, providers, and safe LTV ratios
Available in Layer 4: Advanced Strategies
What To Own - Diversification: Complete
- Diversification is the only free lunch in investing—it reduces risk without sacrificing returns through uncorrelated assets.
- Modern Portfolio Theory shows that combining assets with low correlation creates portfolios that are less volatile than individual holdings.
- Historical examples (2008 GFC, 2020 pandemic, 2022 inflation) prove that diversified portfolios survive crises better than concentrated ones.
Homework
Look at your current portfolio. What would happen if your largest holding dropped 50% tomorrow? Do you have uncorrelated assets to cushion the blow?
Create a simple allocation plan for your next $10,000 to invest. Instead of putting it all in one asset, split it across 3-4 different asset classes based on your risk tolerance and the principles you learned here.
What's Next?
25 minutes