Diversification

The golden rule of investment is

Never put all your eggs in one basket.”

 

 

Remember that profit is the return to risk – no investment is totally risk-free. Therefore we need to make investment choices that align with our situation, goals, time horizon and preferences and importantly, our tolerance for risk.

Diversification is essentially a risk management tool.

Having all your ‘eggs in one basket’ whether that is all in shares or all in property leaves you open to the possibility that should there be a downturn in either market, you will suffer a loss across your entire portfolio.

Diversification increases your chances of maximizing gains and minimizing losses.

Having a diverse portfolio increases your chances of smoothing out the variations around the growth trend line and makes you less exposed to single economic events. For example, if you have all your money invested in mining shares and China’s economy slows, your share prices may fall as large mining companies lose orders. While demand fluctuates over time and is to be expected, the impact may be more significant if it happens at a time when you want to divest and collect the anticipated benefits. (retirement perhaps)

Psychology and the media play a role too. If panic sets in and lots of people sell, thinking prices will go even lower; a raging ‘bear’ market may become a devastating reality! Having a diverse mix of shares may allow you to wait for the sliding ones to recover before cashing in.

The same applies to a property portfolio; again, diversity is wise. It means not necessarily buying in your ‘backyard’ just because it is familiar – Australia is a big place and the ‘Property Market’ is a misnomer. Some states, or locations within those states, can be stalling while others are shifting into a higher gear. That’s why it’s important to choose based on facts and figures and not on what the crowd is doing.

Looking beyond familiar territory and considering other locations can mean taking advantage of demographic changes in one part of the country, or exogenous factors like a recovery in China’s demand for our resources, stimulating jobs growth in another. Depending on your strategy, the relative affordability and rent yield of one location compared to another may be a determinant of the area chosen.

Demand for different types of housing is also a factor to consider. There is no one perfect investment property type. It very much depends on your circumstances, budget, time frames, tax position and also on the features of the property and how it matches the demographics and demand in the area.

Remember the section on Asset Classes Рsome are defensive, like cash and term deposits. These are low risk but low return and all about preserving capital which becomes increasingly important as the investor approaches retirement as you have limited time to recover from any erosion of your wealth.

Growth assets, like shares and property, carry higher risk but also the possibility of higher reward.

Property investment is a relatively stable, long term growth strategy. It is not a ‘get rich quick scheme’, so it’s important to buy based on facts and not emotion and to do so sustainably – don’t over commit.

 

Asset Classes

Assets can be broadly classified

as either

 

DEFENSIVE or GROWTH

We have seen so far that scarcity requires us to make choices about the satisfaction of the competing needs we have in life. Increases in productive capacity imply a more satisfactory answer to the economic problem. More capacity means more employment, more income and more tax revenue.

To increase potential satisfaction, or make the economic pie larger, it is necessary to devote some resources to investment.

(*Implies a more satisfactory answer because it very much depends on how the additional income/goods and services are distributed but that is the realm of normative economics and a different discussion!)

In a specialized economy, we have our income to satisfy our needs first and then wants, via discretionary spending.

Once you have paid tax, you then have the choice to either spend or save your disposable income.

If you are in a position to save and decide to invest, you then have to determine how to make your money work for you.

There are four main asset classes.

They can be broadly classified as either DEFENSIVE or GROWTH assets.

Defensive assets focus on generating an income. There is minimal risk involved, and so the returns are very modest. They are appropriate for those who are very conservative and are not in a position to risk losing any of their capital, e.g. the elderly. Examples are Cash and Fixed Interest securities.

Assets can be financial, paper assets such as bank accounts or shares (pieces of paper that ensure ownership). Assets can also be classed as real, or tangible such as property.

DEFENSIVE ASSETS:

  1. CASH – deposits in the bank that earns interest, typically at a base rate. The investment is highly liquid, that is you can access it at any time. Therefore the financial aggregators, the banks and financial institutions generally, have less certainty about what they can invest the money in and for how long and so are only prepared to pay lower interest. Depending on the time value of money, influenced by the inflation rate, cash in the bank may lose value over time as buying power diminishes.

 

2. FIXED INTEREST – Fixed interest assets are loans to companies (debentures) and government (bonds). They are similarly low risk, though slightly more risky than cash and the returns are a little higher since they are for a fixed term, giving the holder of the security more certainty. Because the term is set (anywhere generally from 1-5 years) these are less liquid assets.

GROWTH ASSETS

Growth assets focus not only on generating an income but also on capital growth, or an increase in the value of the asset over time. The trade-off is that the investor needs to be prepared to ride out any volatility in the market or at worst, suffer a capital loss. Time in the market is more important than timing.

3. PROPERTY – investment in property either indirectly or directly is deemed a growth asset as it not only generates income but also over time, capital gain. Bricks and mortar is a tangible, real asset and isn’t subject to management performance, the returns are contracted in a lease agreement, and the government provides substantial incentives to encourage the supply of and demand for housing. Real estate as an investment lacks liquidity, but capital doesn’t tend to be at risk- volatility in house prices isn’t usually pronounced. There are relatively large entry and exit costs and the asset class suffers the disadvantage of indivisibility.

4. SHARES – Shares can be very profitable, but they carry the highest risk of this asset class. Shares are proportional ownership in a company, and as such are subject to the performance of the management, this may be excellent, or it may be lacking. Your investment as a shareholder may be at the mercy of personality, individual talent or outright bad behaviour!

Their value is dependent on the performance of the company in the broader context of the economy, exogenous influences like the demand for our goods and services internationally (remember X-M in the circular flow), and the management style of individual CEOs and Directors.

Shares are an asset class that provides low-cost entry and liquidity. Given the ease at which shares can be sold, they provide the investor with an opportunity to realize gains progressively or cash in should circumstances change.

However, given the ease of entry and exit, they are also more volatile – investor expectations can become a self-fulfilling prophecy.

In a global economy, international shares are riskier still as they are subject to currency risk – fluctuations in either currency may impact the returns.

Example: If an Australian based investor is expecting USD 10,000 as a return on investment, it may translate into AUD 20,000 if the exchange rate is USD 1 = AUD 2,

BUT if the AUD appreciates to equal to the USD, the return in AUD will be reduced to $10,000. ($1AUD=$1USD)

PROFIT is the return to RISK. The more risk you are prepared to take, higher are the potential returns. Any investment choice needs to be evaluated, taking into account your particular circumstances and stage on the income/life cycle.

Diversification is also a golden rule of investment, that is, not putting ‘all your eggs in one basket’!

Diversifying spreads the risk and helps smooth out volatility across a portfolio.

Different people also have different appetites for risk.